Monday, November 5, 2007

3 Investment Principles Every Young Person Should Know: #1 The Time Value of Money

Since my last post I have had time to read more of Ramit Sethi's, I Will Teach You To Be Rich blog. As I have read the articles and seen the demand for simple financial education...and after many discussions with friends it has become obvious to me that many college and twenty somethings have not been introduced to basic money and investment principles that most close to finance would consider fundamental. For the next few days I'll be laying out the three investment principles every young person should know.

#1 - The Time Value of Money

The basic premise of the time value of money is that all else being equal an investor is better off receiving a certain amount of money today than he is receiving that same amount of money in the future. Basically, money now is better than money tomorrow. To most people this is instinctive, of course you would want money NOW! But why? One would assume that the value of $1 today is equal to the value of $1 a year from now, but this assumption is wrong. The dollar received today is more valuable because of all the ways you can make it grow. Just by putting it in a savings account you'll at least earn interest on it, thereby increasing its future value Here is an example:

You are given the choice between
Option A: $100,000 today
Option B: $100,000 in 3 years.

Lets say you decide to take Option A and invest your $100,000 in a savings account with a simple annual rate of 5%.

Future value of investment at end of first year:
= ($100,000 x 0.05) + $100,000
= $105,000

Next you leave this money untouched and let interest continue to accumulate

Future value of investment at end of second year:
= $100,500 x (1+0.05)
= $110,250

These equations rolled together would be equivalent to:

Future Value = $100,000 x (1+0.05) x (1+0.05) OR
$100,000 x (1+0.05)^2

Using this logic after three years the value of the $100,000 would be:
= $100,000 x (1+0.05)^3
= $115,762.50

This equation allows us to calculate multiple years or periods of interest without having to add each period up individually and is the basis for one of the most basic finance equations out there:

Future Value = Present Value x (1+interest rate)^number of periods

NOW, before you zone out from too many numbers. Here is the bottom line. Option A, in this case, is $15,762.50 more valuable than Option B, who's future value is equal to its present value. And remember, this is just assuming you put the money into a savings account making 5% interest. Option A could in fact be much more valuable if you instead invested the money in the stock market which has averaged approximately %10 percent return per year over the past several decades.

Compounding interest (another discussion in itself) allows our youth to work for us in mighty ways so that the money we have today is in fact much more valuable than money we will have in the future. Albert Einstein was quoted as saying, “The most powerful force in the universe is compound interest.” Understanding the time value of money principle allows us to harness this force and create wealth.

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