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The Time Value of Money and The Rule of 72

January 14, 2018

This post is part of Financial Fixation's Beginner Basics series

 

Managing someone’s personal finances and investments is one of the simplest things on paper. Simply spend less money than you make, payoff debt, and then invest in some high performing stocks and bonds and then sit back and watch your money pile up. Right. If only it were that easy. With new investments available in the market seeming to pop up overnight, money managers claiming to be able to beat the markets, and more businesses trying to get a slice of your pie, managing one’s personal finances may be one of the most complex and frightening endeavors a person has to go through.

 

As with any subject, and finance being no different, it’s important to have a solid understanding of the basics before moving on to more advanced topics. One of the most fundamental principles to grasp in finance is to understand the time value of money, as well as the rule of 72. We’ll get into the rule of 72 in a moment, but for now let’s focus on just the time value of money. The time value of money is understanding that a dollar today will not be equal to one dollar in the future. Because of the effects of inflation, and the fact that money can earn interest through investing, the present value of money is worth more than the same nominal amount of money in the future. This means that $100 today is worth more than $100 in the future. This also shows that just hoarding cash in a box under the mattress isn’t always the wisest thing to do, as time and inflation will slowly erode the value of that cash. As an example, consider that you have $100 now and can earn 5% annually through investments. In one year you would have your initial $100, plus 5% of $100, or an additional amount of $5. The year following that you would then earn interest on the new beginning balance for the year, which would be $105. Over time this compounding impact really adds up as your interest starts earning you more interest. An understanding of the time value of money should lead the reader to understand that money is worth more the sooner it is received.

 

Get That Money, Honey

 

Back in my glory days I used to work at a tennis club in a small mountain town. I mainly worked the front desk by helping people check in and also by ringing people up at the cash register, but when things were slow I also strung tennis rackets on the side to make some extra cash. When it came time to pay the bills people could elect to add to their club tab or they could pay in cash/credit. The club’s tab didn’t accumulate interest as long as the member paid it in full by the end of the year. Every now and then the owner would walk by and watch as customers would elect to put the payment on their credit. Later on, after the customers left, he would come up and say to me “get that money, honey” with a slight smirk. Other days he would see that I had strung several club members’ tennis rackets and request that I call them right away to let them know it was ready. At first, I thought that it was just a nice gesture to let the members know that their rackets were available, but soon after I realized it was because the club wanted the guests to come in so that we could “get that money, honey.”

 

Having a better understanding of the time value of money reminds me of those days at the club. The sooner the club got paid the sooner the owner could invest that cash to start earning compounding interest. This is no different than many large companies having lockboxes throughout the country. Lockboxes are basically just mailing locations that are accessible by a company’s bank. Depending on where a customer is geographically they would mail to a lockbox closest to them. This effectively reduces the time a customer’s check is in the mail which in turn allows the company to deposit the check into their own account a day or two sooner than they could otherwise. Although a day or two of lost interest may not seem like much, over the course of a year some fortune 500 companies could end up missing out on several million dollars.

 

The Rule of 72

 

When dealing with investment return percentages it’s easy to get overwhelmed with all of the lingo. After all, there are many ways for money managers to report performance, including effective return percentage, net and gross returns, return percentage excluding dividends, alpha, and many more. When dealing with future expectations, however, sometimes simpler is better. This is where the rule of 72 can be useful.

 

The rule of 72 is an easy way to determine how many years it will take for an investment to double given an expected return percentage. To use the rule, simply divide 72 by the estimated return percentage per year for an investment, the result is a rough estimate for how many years it will take the investment to double. For example, if you believe you can earn a 9% return every year with a given investment, your initial investment should double in about 8 years (72 divided by 9 equals 8).

 

As an additional example, let’s say that you plan on retiring in fifteen years. When doing your initial financial planning you believe that you can earn a consistent 10% return over the fifteen years. You have an initial investment of $50,000 and you’re curious how much that will end up being upon retirement. Using the rule of 72 you can conclude that your investment will double about two times, this is because 72 divided by 10 equals 7.2, meaning that your money will double nearly every seven years. This equates to your $50,000 initial investment doubling to $100,000, and then doubling once more to become about $200,000.

 

After a brief introduction to the time value of money and the rule of 72 you may want to consider any outstanding loans you may have given others and consider asking for repayment if they’re past due. If you have the ability to get money earlier for something (without being charged a fee) you might as well take advantage of it and start thinking of your personal finances as if it were a business. This can be a tricky topic, especially when dealing with friends and family. I for one am not above sending a friendly email or text as a reminder – as displayed below by a recent text I sent to my sister.

 

 

 

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