Itʼs been a little while, but if youʼve been reading along with the last few newsletters you know that we set out to cover three important basic financial concepts. Thus far, we discussed ʻsimple versus compound interestʼ and ʻdollar-cost-averaging.ʼ Now, letʼs integrate those concepts into a more complete discussion around the “Time Value of Money” (TVoM). The essence of the TVoM is to understand that having a sum of money at this very moment is worth more than having the identical amount of money in the future. The reason it is more valuable today stems from what is understood to be that sumʼs earning potential over time.
This concept is rather intuitive. Consider this, you just inherited $100,000. You have a choice to make: you can have $100,000 today in a lump sum or you can have a lump sum of $100,000 in 5 years. Which do you prefer? No, I havenʼt forgotten any details of the offer and thatʼs why this seems like such a silly thing to consider. Itʼs obvious that you would much rather have $100,000 today instead of $100,000 in 5 years (and not because you could use a new car). Remember, weʼre focusing on investment concepts. So, while yes it would be great to spend that money on something fun, we are going to think about more grandiose options like…retiring, which should be fun, too, I would bet.
For our purposes, letʼs assume that weʼre just focused on this one sum of money and not on your entire retirement picture. Letʼs further assume that you would like to turn the inheritance (from above) into a $500,000. You have two main variables to account for: Time and how much you expect to earn. Using our prior understanding of compound interest; if we can earn 6% per year consistently, then we will have accumulated $500,000 in 27 years. It is the expectation that you can earn a return on your money that prevents you from wanting to accept $100,000 in 5 years as originally proposed. Because if you can earn 6%, then in 5 years you should really receive $133,822. That sum is simply the result of earning 6% for 5 consecutive years. This illustration conveys the time value of money.
Now, letʼs come full circle. You decide that you would like to pursue generating $500,000 sooner. In fact, you would like to use the funds to buy your retirement dream home and you want to retire in 20 years – not 27. How should we approach this? You have two options – earn more by taking greater risk alone or you can also incorporate a savings effort to bolster the balance and improve your chances of reaching your $500,000 goal in 20 years. To do so, you could incorporate one of the previously covered concepts: “Dollar-cost-averaging” (DCA). Recall, DCAʼing is simply the process of creating a systematic contribution from your bank to your investments on a monthly or bi-weekly basis. If we continue to assume youʼre able to earn 6%, we are able to determine that you would be required to save $365.72 per month and in so doing you would reach your $500,000 target seven years sooner.
By utilizing the time value of money, dollar cost averaging and an understanding of how compound interest benefits you, we can start to develop an approach to mathematically achieve your long-term objectives. This represents the essence of goals based financial planning and it is the foundation of our financial planning process. If we create a vision of your financial future together; but on a more comprehensive/global scale, we can begin to craft the meaningful strategies to help you realize your vision using these tried and true mathematical concepts. We can help you to understand HOW to accomplish your objectives. But one key to success is TIME. The most frequently stated regret in our office is, “I wish I started doing this a long time ago.”
We can help you and your children begin taking advantage of the time value of money today. Let us show you how by having a brief conversation about your goals.
by David A. Younis, CFP®, Director of Financial Services