The Time Value of Money is one of the first skills a new investor must learn. Simply put, it answers the question “What is the value to me today, of a dollar that I expect to receive at some point in the future?” This article will walk you through the process of answering that question.
The importance of time in investing can’t be over stressed. When we consider the time value of money, the ideas of compound growth, the present value of money to be received in the future, and the impact of changing interest rates are just three examples of how the passage of time influences the wealth creation process.
To illustrate this point, consider the most recent bull market that began in March 2009 and continues to this day (May 2017).
If we look at this time period from the perspective of a new investor who is entering the market with a lump-sum investment of $10,000, the results of a simple buy-and-hold strategy are outstanding. In just eight years, this investor has more than tripled her original investment, and she has not had to pay any taxes on this newly created wealth. She now has $34,000 to work with for the next phase of her investment plan.
Now let’s go back and change the time frame slightly. Let’s say she waited until March 2010 to invest in the market, instead of March 2009. What’s the impact on her wealth from delaying her start date by one year? As it turns out, it’s pretty significant.
The $10,000 she invested in March 2010 would be worth $22,000 instead of $34,000 if she had started a year earlier. Part of this difference was due to the fact that the missing year (2009) was a particularly strong one. But even if we assumed that all years had the same rate of return, the extra year would yield higher results because the nature of compounding is such that the incremental gains get larger with each passing year. Think of it as a way of turbo-charging your returns over time.
The lesson? The time value of money is extremely important in investing. In a future article on this topic we will delve into a detailed discussion of how to arrive at the time frame that’s appropriate for your specific financial circumstances. You may be under the impression that all you need to know is that you have 25 years until retirement, and that this will protect you from the short-term volatility of the stock market. That may have been ‘conventional thinking’ a few years back, but the market since 2000 has taught us that even long-term investors need to monitor their risk, and make adjustments to their holdings from time to time. We’ll show you how to do this.