It’s Good To Know Time Value of Money

Jim Lorenzen, CFP®

Every time we spend $1, there’s an alternative use we’re rejecting.

For example, I bought a camera that was quite expensive at the time, $500!   I loved photography – we won’t even talk about what I spent on lenses, filters, other gadgets,  film (remember film?) processing and printing. 

I could have invested that $500 and, despite our current economic crisis, would have still made quite a bit of money.

How much you can make on $500 depends, of course, on how you invest it, the return you achieve, and the time period involved.  But, let’s suppose the $500 is invested in something that returns an average annual compound return of 8% over a twenty-year period (not all that unreasonable to assume), a time-value of money computation on a financial calculator shows that the true long-term cost of the camera becomes $2,330 in future dollars!

Expensive camera, huh?

I also like golf – don’t get me started on the cost of lost balls – which not only has an initial cost for equipment, but ongoing costs to play (thankfully, I walk and don’t pay for a cart).  It’s not unusual for a golfer to play a couple of times a month; but even if s/he plays only once a month, walks, and pays only $30 each time, what does THAT add up to – in terms of lost investment capital?

Guess what!  That golfer spent about $7,000 over 20 years, but lost over $17,000 of retirement money, had it been invested in something that returned an average annual compound rate of 8%.

Think 8% is high?  If so, you probably suffer from what psychologists call `recency bias’ – attaching more importance to one event over another only because the occurence was recent.

You might want to pick up a financial calculator next time you’re in an office supply store.  Time value isn’t hard, but it IS eye-opening.