The Time Value of Money
Now that you understand the concepts of risk and return, let’s turn to an element that is at the heart and soul of building wealth and financial security…TIME.
Here is how time can work for you:
- The longer you invest, the more money you will accumulate.
- The more money you invest, the more it will accumulate because of the magic of compound interest.
Compounding works like this . . .
- The interest earned on your investments is reinvested or left on deposit. At the next calculation, interest is earned on the original principal PLUS the reinvested interest. Earning interest on accumulated interest over time generates more and more money.
Compounding also applies to dividends and capital gains on investments when they are reinvested. The following illustration and questions give you a first-hand opportunity to calculate the impact of time on the value of your investment accumulation. Please complete the exercise below before moving ahead to the next section.
How Time Affects The Value Of Money
Investor A invests $2,000 a year for 10 years, beginning at age 25. Investor B waits 10 years, then invests $2,000 a year for 31 years. Compare the total contributions and the total value at retirement of the two investments. This example assumes a 9 percent fixed rate of return, compounded monthly. All interest is left in the account to allow interest to be earned on interest.
|Age||Years||Investor A||Investor B|
|Contributions||Year End Value||Contributions||Year End Value|
|Value at Retirement||$545,344||$352,427|
|Less Total Contributions||($20,000)||($62,000)|
Figure 3. How time effects the value of money, Source: National Institute for Consumer Education, 1998
Using the data for Investors A & B, answer the following questions.
- At $2,000 a year, how much did Investor A invest in the ten years between the ages of 25 and 35?
- What is the value of Investor A’s investment when the Investor is 35?
- At $2,000 a year, how much did Investor B invest over the 31 years, from age 35 through 65?
- What is the value at retirement of Investor A’s investment?
- What is the value at retirement of Investor B’s investment?
- What are Investor A’s net earnings?
- What are Investor B’s net earnings?
- What advice would you give to your children about investing for their retirement?
The answers to questions 1 – 7 can be found at the end of this unit.
Note that Investor A, who invested much less than Investor B, has a much higher nest egg at retirement age, because of a 10-year head start. As you can see from this example, compound interest is especially magical when money is steadily invested and left to grow over a long period.