How to Make the Time Value of Money Work for You

Understanding the time value of money and power of compounding can help you make time and your money work for you. Many people overestimate what they can achieve in the short term and underestimate what they can achieve in the long term.

Illustrating Compounding and the Time Value of Money

A great way to illustrate the power of compounding is through the example of three 19-year-old college students: David, Albert and Sam. David was a dedicated person and contributed $2,000 to his retirement account every year for 50 years. Albert too was a responsible young man and like David, put away $2000 into his retirement account every year for 10 years till he was 28 years old. After that, for a variety of reasons, he stopped contributing. Finally, Sam was a carefree young man who had a lot of fun as a youngster but could never really save any money for the first 10 years. After that, he became serious about planning for retirement and contributed $2,000 every year for the next 40 years.

Assuming their money compounds at 10% every year, who do you think will have the biggest retirement balance when they turn 68? Not surprisingly, David, who contributed every year for 50 years. His retirement account would be about $2.3 million. The surprise is Albert’s retirement account would be considerably bigger than Sam’s even though he made contributions for only 10 years and Sam contributed for 40 years. Because Albert started contributing early, his retirement account would be about $1.4 million, and Sam’s account would be worth less than $1 million.

Although the above example nicely illustrates the power of compounding, it makes one big assumption- that the accounts earn 10% every year for 50 years. That is a very good rate of return and there is no guarantee that anybody could consistently earn that much, especially for so long. Which means between the three things required for compounding—money, time and rate of return—only two are really in one’s control: money and time. Therefore, to maximize the power of compounding one should start early and save as much as possible. (For related reading, see: Top 4 Reasons to Save for Retirement Now.)

Maximizing the Rate of Return

There are however, ways to maximize the rate of return, the third input for compounding, by remembering a few investment tenets:

1. Negative returns have a bigger impact on long-term performance than positive returns. For example, a loss of 50% followed by a gain of 50% does not break even. Although the average return is 0%, the compounded return is a loss of 25%. The same is true if a gain of 50% is followed by a loss of 50%.

2. Volatility is not the same as permanent loss of capital. Volatility can be considered as the price one has to pay to earn returns. In general, investments with high long-term returns tend to come with relatively high volatility. However, losses are crystalized only when investments are sold. Investors that panic when markets are volatile, such as during a recession, sell investments and miss the subsequent recovery. This also illustrates the importance of portfolio construction discussed below.

3. It is important to stay invested. In the last five years, if one had missed the five best months of the equity market, returns would have almost been cut in half from 14.2% to 7.5% per year.

4. Investing for the long term increases the odds of relatively high positive performance. This is another reason why someone like David or even Albert in the example above, would have had better results. For example, over the last 90 years, almost half the time, the daily performance of the equity market was negative. However, if performance was calculated over 15-year increments, then it was positive 100% of the time. In other words, in the last 90 years there has never been a 15-year period when the equity market has returned negative performance. (For related reading, see: Long-Term Investing: Just How Long Do You Mean?)

5. A well-diversified portfolio constructed according to the investor’s risk profile increases the odds of success. Diversification has been called the only free lunch in investing because one can decrease risk without giving up return. A well-diversified portfolio, apart from providing many sources of returns, also reduces the magnitude of negative performance. Equally important, when a diversified portfolio is down in performance one can be confident that the chances of its recovery are relatively high.

All the above can be achieved by good planning. By starting early, having a well-thought-out plan and sticking to it, they can make the time value of money work for them and achieve superior results over time.

(For more from this author, see: The Foundation of a Good Financial Plan.)