Here’s a pop quiz for you: What’s the one thing that we all possess, regardless of our station in life? Here’s a hint: it’s actually more valuable than money. The answer is time.
Now you might be thinking, “How can time be more valuable than money?” Well, there are two reasons. First, time is something we can never get back, unlike money. You can always earn more money, but you can never earn back time once it’s gone. Second, time is what allows your money to grow for you so you can create wealth and financial freedom. This phenomenon is called the time value of money (TVM), and it’s the most important principle you must understand to become a successful investor.
Time Value of Money (TVM)
The time value of money means that a dollar today is worth more than a dollar in the future. How does this work? Let’s start with a basic example. Pretend you have two choices. Either I give you $100 right now or I give you $100 next year. Which do you choose?
Obviously, everybody prefers money sooner than later. But the key difference here is that the $100 I’m giving you right now isn’t going to be spent right away. That’s because you are going to invest it. And that’s where TVM comes in.
If you take my $100 right now, you could put it in your bank account and have it earn, let’s say, 2% interest per year. So after one year, your $100 becomes $102. That means you made a 2% profit because $2 divided by $100 equals 2%.
But what if you accepted my $100 a year from now and invested it in the same bank account? You’d still make a 2% profit, but it happened a year later. In other words, you missed out on your money growing sooner rather than later, so you end up with less money. TVM means that the sooner you invest money, the bigger it will grow.
Now let’s go further. If you had taken my $100 immediately and put it in your 2% interest-earning bank account, you’d have $102 after one year, right? So, what would happen if you kept the $102 in your bank account for another year? Well, it would grow by even more than $2 because of compound interest.
Compound interest is the interest earned on your principal and previously earned interest. In Year 1, you only earned simple interest because the interest only applied to your principal of $100. In Year 2, the 2% interest is applied to your principal and interest of $102 ($100 principal plus $2 interest).
A quick calculation shows that $102 × 1.02% = $104.04. Do you see the magic of compound interest now? The $104.04 balance means you’ve made a 4.04% profit in two years just by doing nothing. Because compound interest applies to your principal and earned interest, you are making more money just by letting your money stay in your account. Your interest from Year 1 produced an extra 4-cent profit for you. Now that’s not much money, but over time compound interest grows incredibly fast, especially at higher interest rates and over longer periods of time.
Now imagine you want to keep investing, so you leave the $104.04 in that same account and let it accrue (grow) at 2% interest every year for 10 years. Using a financial calculator, enter $100 for the present value (or PV) or Starting Principal, 2 for the interest (or INT), 10 for the number of periods (or N), and 0 for payment (or PMT). Now select future value (or FV) or Calculate. The result reveals that after 10 years, the initial $100 you invested is now worth $121.90. So in 10 years, you’ve made $21.90 by doing absolutely nothing—a return on investment (ROI) of 21.90%. This is because $21.90/$100 = 21.90%.
Note: You can find a financial calculator online for free—this is a good one: www.calculator.net/finance-calculator.html.
Now let’s assume you kept the $100 in the same account for 20 years. Enter the same numbers as before (100 for PV, 2 for INT), but enter the number 20 for N. Now select FV. That means that after 20 years at 2% interest, your $100 is now worth $148.59—a 48.59% ROI.
Let’s go further and assume you leave the $100 in there for 30 years. Your $100 turns into $181.14—an 81.14% ROI.
And finally, let’s say you leave the $100 in the account for 40 years. What happens then? Your $100 becomes $220.80—an ROI of 120.80%.
Did you notice the pattern in the previous examples? The longer you kept the money in your account as it earned interest, the more money you ended up with. That’s the time value of money. Essentially, time is more valuable than money for an investor because time is the most important factor in making money grow.
But wait. Did you notice something else in those examples? Think about the patterns in the ROIs. Not only did your ROI grow as time went on, but after Year 40, your ROI was over 100%. This brings us to another key concept: Given enough time, compound interest means the majority of your investment gains will come from interest, not principal. Don’t believe me? Find a financial calculator online and enter $100 for your principal, 2% for your interest rate, and 50 years for your number of periods. Then do the same thing but with 60 years for your number of periods. The amount of interest you’ve earned over those years accounts for an increasing share of your overall balance. That’s the power of time and compound interest. But TVM and compound interest don’t just apply to leaving your money in the bank. They also apply when you’re investing in stocks, mutual funds, and similar instruments, which we will discuss shortly. And since these other investments can earn you more than 2% on average, your money can grow a whole lot faster than it did in the examples we just covered.
Before we move on to other concepts, I want to give you a fun (though implausible) example just to show you how important time is in growing your money. You may be familiar with the animated TV series Futurama, in which a young pizza delivery boy named Fry is accidentally transported 1,000 years into the future. In one of the early episodes of the show, Fry mentions that he had less than a dollar in his bank account 1,000 years ago. So, he heads to the bank and is shocked to find that compound interest that’s accrued over 1,000 years has made him rich beyond his wildest dreams.
So here’s the exercise based on Futurama. On the financial calculator website, enter $100 for your principal, 2% for the annual interest, and 0 for PMT, just like before. Now enter 1,000 years for the number of periods (N) and select future value (or FV) or Calculate. In 1,000 years, your $100 earning 2% a year would be worth $39,826,465,165.84! If only time machines were real, anyone could become a billionaire!
Rule of 72
Now back to reality. What if you just want to find out how long it would take for your money to double? In other words, how long would it take to make a 100% profit? There’s a simple calculation for that called the Rule of 72. The Rule of 72 states that the number of years (or periods) required to double an investment’s value is calculated by dividing 72 by the investment’s annual return on investment (ROI).
Here’s an example. You put $1,000 in a particular investment that has an average ROI of 6% per year. So divide 72 by 6 and what do you get? 12. That means if you invested $1,000 in something that has an average ROI of 6% per year, it would take 12 years to double your money to $2,000. A very simple rule of thumb to remember is this: The higher your ROI, the less time it will take to double your money. For example, if that same investment had a 10% ROI, then dividing 72 by 10 results in 7.2—you would double your $1,000 in just 7.2 years. Simple, isn’t it?
Present Value versus Future Value
Now let’s look at the concepts of present value (PV) and future value (FV). Imagine that you want to save up $10,000 for a globe-trotting vacation five years from now. You do have some money saved up, and you would like to invest it in something with a 4% annual ROI so that it’s worth $10,000 in five years. How much money would you need to invest today so that you have the $10,000 you need for your trip in five years?
To find the answer, enter the following information into a financial calculator: 5 for the number of years (or N), $10,000 for the future value (or FV), 0 for your PMT, and 4 for the ROI (or INT). Then select PV (present value) or Calculate, and the result is $8,219.26.
Note: Some financial calculators may return a value that is one cent off because of rounding.
So what does this mean? Basically, if your future value is $10,000 (the amount you need in the future), you need it in five years, and you want to invest in something with a 4% annual ROI, then you would need to invest $8,219.26 today. This number is your present value, which is the current value of a future sum of money. So, if you have a specific financial goal (future value) and you know your timeframe (number of periods) and you know the ROI (interest) of your investment, it’s very easy to find out how much you need to invest today—your present value.
This process of finding your present value is known as discounting. That’s because you are discounting a known future value to the present to find the smaller present value that you need today.
The formula also works in the opposite direction. Say you had $8,219.26 in your bank account right now. You want to invest it in something with a 4% annual ROI, and you want to know how much it will be worth in five years. On the financial calculator, enter $8,219.26 for your present value, 5 for your number of periods, 0 for your PMT, and 4 for your ROI (or INT). Now select FV (future value). What do you get? $10,000. This process of finding a future value is known as compounding. That’s because you are taking a known present value and compounding it with a specific ROI and time period to find that larger future value. Compounding is the opposite of discounting.
In fact, as long as you know any three of these four values—N, INT, FV or PV—you can find the missing fourth value with your financial calculator. Remember, N is the number of years or periods you’ll be investing, INT is the interest rate or rate of return you’ll be investing at, FV is the future value of your money at the end of the investing period, and PV is the present value of the money you’ll be investing today.
Try it out for yourself. Enter $8,219.26 for your present value, $10,000 for your future value, 0 for your PMT, and 4 for your ROI. Now calculate N (number of periods) and what do you get? Five years! With a financial calculator, it’s very easy to find out the relevant information for your financial plans.
Consistent Payments (PMT)
Let’s take this knowledge one step further. On any financial calculator, there is a fifth value that is sometimes entered or is derived from the other four values. This is the payment value, often abbreviated PMT, as I mentioned before. This value generally refers to ongoing deposits you make in a stock, mutual fund, or exchange-traded fund (ETF).
Let’s pretend that you invest $1,000 right now in one of those three investment vehicles and you assume it will have an annual ROI of 3%. You will keep your $1,000 invested for 20 years. So you would just enter $1,000 for the present value, 3 for the ROI, and 20 for the number of periods, which gives you a future value of $1,806.11. So if you invest $1,000 and have a 3% annual ROI, you would have $1,806.11 in 20 years, right? But remember: that future value of $1,806.11 assumes you are not investing any additional money at all beyond that first $1,000.
But what if you do want to deposit more money into this investment to make the future value even bigger? In fact, what if you want to deposit a specific amount of money at regular intervals? Well, that is where the PMT value comes in.
Take the original information we had: a $1,000 present value, a 3% annual ROI, and a time period of 20 years. Now let’s say you want to invest an additional $200 every year for 20 years into this stock, mutual fund, or ETF. On your financial calculator, enter $1,000 for the present value, 3 for the ROI, 20 for the number of periods, and finally 200 for PMT. Now select future value. What do you get? $7,180.19.
Do you see how the simple act of investing an additional $200 every year for 20 years has resulted in a much bigger future value? It’s almost four times the future value in the original calculation where you didn’t invest anything beyond the initial $1,000. And all you had to do was make one deposit of $200 every year for 20 years. This brings us back again to the time value of money. Time (number of periods) can grow money, but the rate of growth is also dependent on the size of your ROI and the size of your principal. In the same way that a higher ROI and a higher number of periods lead to a higher future value, so does a higher principal. Why? Because the $200 you added every year increased the size of your principal, which in turn was subject to that 3% ROI. And because the increasingly larger principal is accruing interest and then accruing more interest on top of that, your investment will grow much larger. That brings us back to a now-familiar concept—compound interest.
So now that we’ve covered fundamental financial concepts, let’s delve further to see how we can apply these concepts to some potentially more profitable investments.