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Compounding: Our great friend--and harshest enemy.

February 22, 2011
Jonathan Clements, Director of Financial Education, Citi Personal Wealth Management

It can be tough to get ourselves to save more, to invest more in stocks, to diversify our investments or to take the threat from inflation seriously.

What should we do? Consider giving some thought to compounding, the investment process by which money grows or shrinks over time, with each year's gains or losses building on top of prior results. For instance, if you earn 10% this year and 10% next year, your cumulative return would be 21%, not 20%.

Compounding can be our greatest friend--and harshest enemy. For proof, consider four hypothetical examples.

Start saving today. If you invest $10,000 at a 5% fixed rate per year, you would have $43,219 after 30 years. But if you delay saving by five years, so you invest for only 25 years, your $10,000 would grow to just $33,864.

Invest in stocks. Let's say you put more into stocks. There are never guarantees, but if your long-run return is increased by one percentage point a year, from 5% to 6%, then your $10,000 would be worth $57,435 after 30 years, versus the $43,219 with the 5% return.

Diversify investments. Investing heavily in stocks brings with it the risk of large losses--and the larger those losses, the harder it is to recover. If you lose 20%, you need a 25% gain to get back to even. If you give up 50%, you require a 100% rebound. What if you lose 75%? Now, you need a 300% gain to make yourself whole. Diversifying won't prevent you from losing money. But it can reduce the risk of truly devastating losses. To that end, you might purchase a globally diversified mix of stocks, rather than focusing on a single sector or a handful of stocks, and also keep some money in more conservative investments.

Consider inflation. Today, inflation may not seem like a big threat. But thanks to compounding, even modest inflation can be awfully destructive. For instance, 3% annual inflation will cut the value of $1 in half in just 23 years. One implication: If your investment returns aren't outpacing the inflation rate, the spending power of your money won't grow over time.

INVESTMENT PRODUCTS: NOT FDIC INSURED • NO BANK GUARANTEE • MAY LOSE VALUE

This is intended for informational purposes only. It is not an offer to buy or sell any of the securities, insurance products, investments, or other products named.

Diversification does not ensure profit or protect against loss. Past performance is no guarantee of future results. The investment strategies presented may not be appropriate for every investor. Individuals should review the terms and conditions and risks involved with specific products or services.

S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market. An investment cannot be made directly in a market index.

© 2011 Citigroup Inc. Citi Personal Wealth Management is a business of Citigroup Inc., which offers investment products through Citigroup Global Markets Inc. ("CGMI"), member SIPC. CGMI and Citibank, N.A. are affiliated companies under the common control of Citigroup Inc.

Citi and Citi with Arc Design are registered service marks of Citigroup Inc or its affiliates.

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