Understanding the Time Value of Money
In the realm of financial planning, time is our most valuable asset. It’s available to all of us, providing each individual with the same opportunity to optimize its value in building wealth. It’s the only resource we all have over which we have some degree of control. However, it is a wasting resource if it is not optimally utilized. Each day that passes, without some contribution of money, either in savings or interest, the cost of our financial goals increases. As time marches on, the obstacles to achieving goals of any time horizon become increasingly insurmountable.
The more time money has to work, the less it needs to grow; meaning, there is less need to have to generate high rates of return which almost always requires assuming greater risks. Given enough time, money will let the compounding of interest work its exponential magic; so, there is less need for higher, riskier rates of return. Therefore, it can be said that, by waiting to start saving or investing, the costs of achieving your goals increase – either in actual dollars required to achieved them or in the amount of risk you will have to assume to “catch up.”
The Cost of Waiting
The cost of waiting is best illustrated with a comparison of two savers – John and Karen.
John invests $20,000 per year from age 25 to 45, before he stops making any more contributions to his retirement plan.
Karen doesn’t invest from age 25 to 45, but then contributes $20,000 per year from age 45 to 65.
Assuming an investment return of 6%, by age 65, John would have $2,500,000, whereas Karen would only have $790,000!
Time can help us overcome other the other, inevitable obstacles to achieving our financial goals:
Inflation is one of time’s worst enemies. The longer the time horizon, the longer inflation can eat away at the true value of money. At a normal inflation rate of 3%, the value of money is cut in half after 23 years. The cost of financial goals must incorporate the cost of inflation when calculating how much savings will be required to achieve them.
With enough time to allow your earnings on savings to compound, your savings growth will have a much greater capacity to match or exceed the rate of inflation.
Taxes are the one certainty of life that can obstruct your progress towards reaching your goals. The good news is that, with the proper planning, and the use of the right tools, they can be minimized to reduce their impact. Consider the effect on your long-term savings (aided by the time value of money) when you can convert tax dollars into savings dollars.
Yes, life happens, and very rarely in the way we anticipate, which is why financial goals must be defined, calculated, measured and reviewed frequently so that the necessary adjustments can be made to keep you on the right road when life throws you a curve. Time gives us the ability to assess, adjust, and get back on track.
The number of people approaching retirement unprepared and underfunded is increasing at an alarming rate. And, while many will point to stock market or real estate crashes, or the unexpected, or some other reason they couldn’t save enough, you can bet that procrastination and the misunderstanding of time as an asset was a key element in their failure.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2023 Advisor Websites.