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The Five Keys to Investing Success
Get on the path to your financial goals -- long-term and near-term -- by tapping into Kiplinger's core investment advice.
By the Editors of Kiplinger's Personal Finance Magazine
December 28, 2007
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Key #4: Keep Time on Your Side
A penny saved is a penny earned—or so the saying goes. In fact, a penny saved may be more or less than a penny earned, depending on when it is earned and how it is saved. The reason is rooted in a concept called the time value of money (and its close cousin, opportunity cost).
Which would you rather have, $10,000 today or $10,000 a year from today? Of course, you’d choose the take the money now. Besides possessing the sure knowledge that a bird in the hand is worth two in the bush, you understand that the value of that $10,000 you have to wait a year for will be eroded by a year’s worth of inflation and a year’s worth of lost interest on the money. To put a dollar figure on it, if inflation is 4% and you could earn 5% interest in a year, the thrill of being handed $10,000 today is worth about 9%, or $900, more than the thrill of being handed $10,000 a year from today.
The time value of money works against you if you’re the one waiting to collect the money, but it works in your favor if you’re the one who has to pay. Success often lies in being able to identify the proper side of the equation. You just need to keep in mind this principle—a dollar you pay or receive today is worth more than a dollar you pay or receive tomorrow. A couple of examples illustrate why:
Paying the kids’ college bills
Your future rocket scientist faces a four-year education cost of about $450,000 when he or she enters an average-priced private college in 18 years. That’s a huge sum, but because you’re familiar with the time value of money, you know the smart thing to do is to find a way to pay those bills today, when your dollars are worth more than they will be in 18 years. Assuming a time value for the money of 10% per year—meaning you could earn that much on the money between now and the time you have to pay it—the value of the $450,000 you need 18 years from now is about $81,000. So, if you had that amount available and salted it away in an investment earning 10% a year, you’d have the bills covered. Since it’s unlikely you’ve got that amount, invest as much of it as you can as soon as you can to get the time value of money working for you, easing some of the burden when the college bills come due.
Paying off the mortgage
Failing to understand how the time value of money works can cause you to think you’re doing something smart when you may not be. For instance, you may have heard praises sung for the 15-year mortgage. Because you pay it off sooner than a 30-year loan, you pay less interest and save thousands of dollars. But the homeowner with the 15-year mortgage parts with the money sooner than the 30-year buyer, and the time value of money suggests some caution may be in order before making extravagant claims of savings. Here’s where opportunity cost—the cost of doing one thing and not another—comes into play. You need the answers to two questions: What else might you do with the extra money you’d spend on the higher monthly payments required by the 15-year mortgage? How much could it earn if you invested it in something else? Suppose it costs you an extra $200 a month to pay off the loan in 15 years instead of 30. That’s $200 a month not available for something else—investing in a mutual fund, for example. Say the mortgage rate is 5% and the mutual fund earns 10%. You could benefit from that 5% difference by putting the money in the fund instead of paying off the mortgage. That $200 a month earning 5% compounded for 15 years grows to almost $53,500. That’s your opportunity cost to pay off your mortgage early, and before you congratulate yourself about how much you’ve saved instead of taking a 30-year mortgage, you need to subtract it from your savings.
