Learn about the time value of money!
I can pinpoint the moment when I decided to become an investor. I was sitting in a large auditorium at Brigham Young University and my financial planning professor was teaching about the time value of money. As he explained the concepts and we started doing calculations, my eyes got big, my heart started racing, and I stood up and proclaimed, “I will be an investor!” Maybe it wasn’t quite that dramatic, but learning about the time value of money truly committed me to becoming an investor.
So what is the time value of money? In the simplest terms, the time value of money refers to the fact if I had the choice of receiving one dollar today or one dollar in the future, I would much rather receive the dollar today because it is more valuable. But why is that dollar today more valuable?
There are two answers to this question—interest and inflation. Interest refers to the financial gain you receive beyond your initial investment. Inflation is the rate at which the prices for goods and services rise over time. A dollar today is more valuable because of its potential to earn interest and because it can buy more goods and services than a dollar in the future.
Both interest and inflation should encourage you to start investing early. Earning interest that keeps pace with inflation is essential to maintaining the value of hard-earned money. However, earning a rate of interest that outpaces the rate of inflation is the goal of many investors as they save for future needs. It is in this situation that money starts working for you—and the longer that money works, the more money it may make for you.
Let’s demonstrate this concept using a time value of money calculation. You and a friend are both 30 years old and decide it is time to start investing. You each agree to invest $5,500 a year (the current annual contribution limit for an IRA). We will assume that the investment can earn an average annual interest rate of 8% and that annual inflation averages 3%. In other words, we assume that you can earn 5% interest beyond inflation. You get started right away and diligently make your annual $5,500 contribution. Your friend, however, drags his feet, preferring to spend his money elsewhere. Finally, after ten years, you convince him that he has to start investing. He agrees and you both make $5,500 annual contributions to your respective accounts until you both retire at age 70.
What is the end result for you and your friend? In all, you invested $55,000 more than your friend because you started ten years earlier. However, your friends account value at age 70 is approximately $365,000, whereas your account value is approximately $664,000. The time value of those ten years when you were investing and your friend was dawdling was a whopping $299,000! And the kicker is that we have already adjusted for inflation so those values are in today’s dollars.
The moral of the story is this, invest early and often to maximize the power of the time value of money.
Have a question about the time value of money? Send it to me in the Have a Question box