I am purposely discussing The Time Value of Money concept in a prominent
section of this website. I want to emphasize that being young has a big
financial advantage: the accumulation of money grows exponentially if you
start saving in the early adult years. The dollar amounts need not be large;
time will grow it for you.
Examples are all around you. The person who bought a
house in the 1940’s now worth 20 times its cost. A friend who purchased a
McDonald’s franchise for $30,000 in the early 1960’s now worth millions. The
engagement ring that cost $2,000 twenty five years ago is now worth $12,000.
These are all examples of asset appreciation and wealth building driven, in
part, by the Time Value of Money.
The Time Value of Money concept can also be
effectively applied to wealth distribution. The teacher who retires and is
given a pension option of: $140,000 today; or $1,300 a month for the rest of
her life. The lottery winner, who has to choose between a lump sum payment,
or installment payments over 20 years. Your car payment, mortgage, and
investments all use time value of money concepts.
Normally, when the Time Value of Money is discussed,
most people think of the old adage: “A dollar today is worth more then a
dollar tomorrow.” While most investors also believe this, it may or may not
be true, because the adage implies the investor has a “risk free” asset. Do
you know that in the late 1990’s, some of the Japanese banks were “paying” a
negative return on their savings accounts? Depositors would receive back
slightly less then their original deposits. The economy was so bad in Japan,
that a very small guaranteed loss was a lot better then the market place
alternatives. For approximately 20 years, from 1985 to 2005, the Japanese
real estate and stock market took severe hits (losses). My point is that
making rate of return assumptions using computer spread sheets is easy. What
the Japanese learned was that it’s difficult to achieve these assumptions. In
the early 1980’s, investors did notice that Japan’s economy was “hot.” Few
people, however, imagined the 20-year economic downturn that followed.
Today, many U.S. investors are solely interested in making their “return”,
and are jeopardizing their principal savings, while trying to get a little
extra cash flow. Some retirees are now buying “junk bonds” (i.e. high risk
debt securities with high interest rates) to generate higher current income
levels. In effect, they are emphasizing current cash flow needs over
principal protection, which is usually a mistake.
Recently, some hedge fund investors lost significant
money in Bayou Management, when the founder absconded with their money. The
founder promised to turn $100 million into $7.1 billion. Promising a 71
“bagger” should have raised concerns. These investors lost sight of
appropriate risk / reward levels. Understanding interest compounding should
have alerted these investors to the fact that there was a problem. Some of
the best investments for the past 25 years were Berkshire Hathaway, General
Electric, and AIG. These companies grew their businesses 15% to 20% per
year; their shareholders became very wealthy with these returns. What
possessed intelligent money managers to believe that a relatively small and
undistinguished hedge fund could duplicate and surpass the results that only
a few achieved over the past quarter century? Be careful and skeptical when
relying on overly optimistic promises and time value of money projections.
Calculations don’t make money; it’s the people and infrastructure behind the
calculations that make money.
The Time Value of Money does not make you “bullet
proof” in the real world of investing:
It does not protect you from the loss of principal by
investing in the common stock of companies that continually report losses or
worse, eventually file for bankruptcy.
It does not protect you from the risk of loss by
investing in fixed rate bonds when interest rates are very low, and then
watching the bond’s value fall, over time, as market rates rise.
But the Time Value of Money does offer some powerful
advantages for patient investors. Investments with low to medium risk
profiles are likely to grow at relatively consistent rates over the long
Low risk investments include:
Commercial bank deposits
U.S. Treasury Securities, as well as, Government Sponsored
Medium Risk Investments include:
Corporate bonds that are rated investment grade
Blue Chip U.S. stocks, including many of the companies in the Fortune
500 list (published annually by Fortune magazine).
Time Value Tables
Try to visualize how time and rate affects the
value of money.