In business school, two of the core principles taught in intro finance courses are the time value of money and compound interest. Grasping these concepts is crucial in understanding the importance of beginning to invest as early as possible. Most people are familiar with these concepts but do not have a formal definition or framework for understanding them.
1. Time Value of Money: The idea that money at the present time is worth more than the same amount in the future, due to its potential earning capacity. In simpler terms, $20 is worth more today than $20 a year from now, because I have the potential to earn interest on the money I receive today. The key takeaway is that provided money can earn interest, any amount of money is worth more the sooner it is received.
2. Compound Interest: Interest calculated on the initial principal and accumulated interest, or in simpler terms, “interest on interest”.
Now why does this all matter? Well, all of us are going to have to retire someday, some of us sooner than others, but without knowledge of these key concepts we’ll all have a tough time getting there. For the example below, imagine that you are investing $5,000 annually in the S&P 500, which has returned roughly 9% annually since 1928. For the sake of this calculation we will assume that the initial investment account starts at zero and that the $5,000 investment will be made at the end of each year.
|Contributions Per Year||1||1||1|
|Amount of Contribution||$5,000||$5,000||$5,000|
|Future Value (Age 65)||$1,689,412.23||$681,537.69||$255,800.60|
As you can see by the first column, a mere $5,000 invested annually grows to roughly $1.7 million dollars over forty years. I know, I know, adjusted for inflation the number will be lower but the principle I am trying to illustrate remains the same. The second and third column show the investment return over thirty and twenty years respectively. As you can see, with only 10 years less time invested, the investment return is over $1 million dollars lower. Investing over twenty years yields a mere $255 thousand, still a significant amount, but much lower than what could have been had the investment had more time to compound.
As always, if you have any questions feel free to reach out and I’ll get back to you as soon as I can.