Have you ever been to a restaurant or had a meal in which there was a “secret sauce”? Something special, something unique, that identifies that menu item more as an experience than just another bite to eat? Well, in the finance world, there is a secret sauce that is absolutely amazing and I honestly can’t believe it’s kept on the down-low from so many people.
What I am talking about here is a concept called “The Time-Value of Money” (TVM). A very similar idea to it is compound interest, and that one usually rings the memory bells of more people. However, I’m finding many individuals don’t really understand just how much the TVM can benefit them nor what it means. I hope you’re ready for a delicacy, folks, because we’re about to open up that secret sauce.
The basic construct of the TVM is that “a dollar today is worth more than a dollar tomorrow.” (I would cite a specific source here, but honestly this is in almost every finance/accounting textbook known to man and it’s pretty clear I’m not the creator of this concept, just a curator.) Essentially what it means is that if you have $1 today, you could theoretically invest it for a 10% return (10% is just for the sake of easy numbers in the example), and in a year that $1 is now worth $1.10 a year from now. $1 x 10% = $0.10. Add that to the $1 you already have and boom, $1.10. Easy peasy.
So why is that $1 today better than “a dollar tomorrow”? (More accurately it’s better than $1 dollar a year from now. The day-to-day change is minuscule, therefore this is easier to see when we think in terms of years.) First step: how much is a dollar “tomorrow” worth? Well, that question is answered by figuring out how much we would need to invest today to have $1 in a year. Keeping things equal from above, assuming we get 10% return each year, that number is roughly $0.91. Now you tell me, which is better: $1 today, that turns into $1.10 in a year, or $0.91 that turns into $1 in a year?
By now you could be thinking, “Ok, Aaron, I get it. $1 now is better because it can be invested. What does that have to do with being the secret-sauce of the financial world?” Good question! Let’s say you leave that $1 from today in the market for a year, now it’s worth $1.10. But why stop there? Let’s leave it in the market another year for another 10% return. Now that $1 today is worth $1.21 in two years. In three years it’s worth $1.33, and in four years, $1.46. Think about that. Forty-six percent overall growth on your investment in 4 years. Not a bad ROI if you ask me.
Why is that important? Because as we saw above, this is compound interest at its finest and more importantly, it is compound interest working for you. We use $1 for simplicity sake, but instead, let’s use $1,000. At our same percentages, that $1,000 becomes $1,100 in a year, then $1,210 then two, then $1,331 in three, and $1,464 in four years.
Ok, enough with the little examples. Those numbers are small potatoes. How can we use this knowledge and get some tasty enjoyment of this secret sauce? Check it out:
The median household income in the United States for 2020 was roughly $67,5001, but we’ll go with $68,000 for ease of numbers. If you were to invest 10% of that income per year ($6,800 per year) in monthly increments (~$567 per month), you would have $7,120 in a year (assuming 10% growth rate, like we did above). But we’re not done yet! Let’s say you’re really feeling the juice on this stuff and leave it in for 5 years, all while consistently adding $567 a month to keep the investment machine rolling. That puts us just shy of $44,000 (if you wanted to know, it’s $43,881). You invested $6,800 for 5 years ($34,000 total) and you’ve got nearly an extra ten grand? Not a bad gig.
This is the part where I get really excited. I’ve said it before and I’ll probably say it thousands of more times, but the biggest factor of the TVM is time. Let’s say you are in your early 30s and looking to retire in your mid-60s. Using the same household income from above, let’s run this out for 35 years and see what happens. Ready? Ready?? It’s over two million dollars. $2.15M, actually. Oh, and by the way, you never changed your annual investment amount. Which means two things: 1) you should have probably looked for a new job because you didn’t get a pay raise in 35 years, and 2) you put in $6,800 a year, over 35 years, for a total of $238,000. The rest of that is all growth, my friend. Nearly 10x growth, and we didn’t even consider if you already had money saved for retirement or talk about an employer match. Tastin’ the secret sauce, yet?
The biggest factor of the TVM is time.
In case you didn’t think it could get any better, it does. When I coach people for their personal finances, we usually run this model out investing 15% of annual income, not just 10%. Would you like to know what happens for a $68,000 income that invests 15% over 35 years on a 10% average growth rate? It becomes nearly $3,250,000. Mmmmm… saucy.
So what does this look like for you? Well, because this is a blog and not a face-to-face conversation where I can show you my fancy-schmancy Excel worksheet (kinda makes me sad, I love showing people my cool Excel worksheets), I’ve got the next best thing: add the fancy-schmancy function to the blog post! You can run all sorts of scenarios in the below table to satiate your curiosity.
After checking out those numbers, some of you are probably pretty freaking excited. In fact, you might have started looking for some investment professionals now. That’s awesome, but let’s hold the Google search for just a moment. Some of you checking out those numbers may realized a couple things: maybe retirement is a lot closer than 35 years, and you don’t have a whole lot saved. Maybe your annual income figure looks impressive, but you’re living paycheck-to-paycheck and there’s no way you can invest 15% of your income on a monthly basis.
First of all, if you are struggling, I want you to know you are not alone and there is a way out. It may take some time and effort, but you can build a legacy and you can sort out whatever the mess is. These stories don’t make the 6 o’clock news or get millions of clicks on social media, but people do it every day. You can, too. The first step to any of this is getting on a budget, followed by getting out of debt and building up an emergency fund. There are many resources out in the world for all three of those things, but if you’d like some help and talk to a real life person who coaches people with their finances, you can schedule a free consultation with me here. Let’s get you on the road to winning.
My friends, the secret sauce of the finance world isn’t that complicated, and it isn’t for a select few. Anyone can do this; everyone should do this. Please note to do this well, you may need help from a professional investment advisor. If you are not sure who to trust with something like that, talk to few different ones and look for someone who teaches you the process and wants you to understand the entire situation. If you’re still not sure who to go to, contact me. I’m not an investment professional, but I know quite a few who would be more than happy to help you.
1: https://www.census.gov/library/publications/2021/demo/p60-273.html