Time value of money is one of the most important concepts in finance and states that one dollar is more valuable today than one dollar is a year from now.
Joshua P. Preiss, CFA®
Feb. 13th, 2018
Time value of money is one of the most fundamental concepts in finance and states that one dollar is more valuable today than one dollar is a year from now. This is because a dollar today can be invested to earn interest, and this interest can be reinvested in order to earn more interest and so on in a process called compounding interest.
Scenario (Power of Time)
This concept is much easier understood in an example. If an investor has $10,000 to invest today and they can earn 4.00% a year by investing it in individual bonds, the first year they will earn $400, which can then be reinvested to earn interest in the next period. The next period the investor will earn $416.00 in interest due to the larger principal amount at the beginning of the period, and by year ten the investor will be earning almost $570 in interest, or 42% more than year one without adding any additional funds to the portfolio. A breakdown of a ten-year investment of $10,000 earning 4% interest annually can be seen below. This chart shows the power time and compound interest can have on the value of a portfolio and highlights the importance of investing money rather than keeping it in cash and cash-like investments.
This concept is crucial to retirement planning, as when someone begins investing may be one the most important factor in the size of their nest egg at retirement. To highlight the importance of time in investing, below is a chart showing three scenarios. All three scenarios involve investing $200,000 throughout the course of a career, however, each one involves beginning investing at different ages. This scenario assumes a 5% annual growth rate for all invested funds.
The Blue line represents a scenario of an investor who begins investing $5,000 per year at age 25 for 40 years. This scenario results in a total portfolio value of $604,000 at age 65, with over $400,000 in interest earned, or double their own contributions to the portfolio.
The Orange line represents someone who begins investing $6,666.67 per year at age 35 resulting in a nest egg of $443,000 at age 65.
The Yellow line represents someone who beings investing $10,000 per year at age 45 resulting in a nest egg of only $330,000 at age 65.
This example highlights the importance of investing early and the drastic impact time can have on a portfolio’s value at retirement.
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