There are certain subjects that come up so regularly that we thought it might be helpful to address them here. There are only four points, but each one of them has a distinct bearing on realizing the full potential of an investment strategy.

One of our favorite clients claims he sends his grown children compound interest tables every year as Christmas presents. The story may be true since his net worth is a wonderful testimony to the powers of compounding.

Years ago, Warren Buffett wrote that the Native Americans who received $24 from the sale of Manhattan Island may have gotten the better deal. He pointed out that if the $24 had been invested at only 6% interest, it would have grown to a higher value than the multi-billion dollar current real estate value of Manhattan.

The simple table below shows the dramatic effect of compounding on a $10,000 investment, even at relatively modest rates.

While compounding is powerful, and can produce significant wealth over time, the key to its success is to avoid major losses along the way. Thus, as Mr. Buffett has said, "The first rule of investing is, 'Don't lose,' and the second rule is, 'Don't forget rule number one'."

There is a perception among some investors that stocks are "risky" and bonds are "safe." The truth is that while bonds have contractual aspects which make their returns more predictable over the life of the bond, bond prices can be as volatile as stock prices, and bonds are subject to the risk of default. Bonds are also subject to the more subtle risk that inflation will erode the real value of the principal.

On the other hand, stocks of sound companies purchased at attractive prices can be conservative long-term investments. In addition, stocks have historically produced higher total returns than bonds over the years and have thus provided greater protection against inflation.

We believe investors should look at stocks, bonds and interest bearing cash instruments as competing alternatives for investment. None is automatically superior. Given your investment goals, income needs, etc., your asset allocation should depend on the relative values of these alternatives. The appropriate allocation may change from time to time as market conditions change.

Cash dividends and interest hold a special fascination for many clients. The old Bostonians were taught that it was prudent to spend the income produced by securities, but not to invade the principal. We would argue that this simple homily over-simplifies the situation. Consider these three cases:

1. A stock that pays a $5 dividend and rises in price from $100 to $105 over the course of the year has produced a total return of $10 or 10%.
2. A $100 bond which pays $10 in interest and stays at $100 all year has also produced a total return of 10%.
3. A $100 stock that pays no dividend, but whose price rises to $110, has also earned a total return of 10%.

We believe that these results, tax considerations aside, are equally desirable. In each case, the investor's total wealth has increased by $10. The issue of prudence involves the amount which is withdrawn and spent, not the source of the funds. However, we would agree that spending more than the $10 total return will jeopardize future earning power. In fact, in an inflationary environment, it will be important to reinvest part of the $10, if possible, to try to maintain the spending power of future returns.

Some investors have trouble selling a security for less than its cost. Others hold on to securities because they won't confront the tax liability. In the first case, pride prevents selling a poor holding, and in the second, resentment towards the IRS may get in the way of maximizing after-tax returns. These are two sides to the same misconception.

Common sense dictates valuing all securities at current market prices and asking the question, "Will my long-term investment results be better if I keep my existing security, or if I sell it and reinvest the after-tax proceeds in a security with better prospects?" This is not to say that we favor short-term trading -- far from it -- but it can be a losing strategy to postpone selling for tax-related or emotional reasons.