Understanding Time Value of Money & the Rule of 72

Your biggest ally for saving and investing is time. If you’re young and have minimal savings, fret not! This is one area you have a leg up on your elders – that is, if you take advantage of it (remind your parents of this next time they bug you about your finances). If you take one thing away from any post on this blog, it should be this: start saving EARLY. As in RIGHT NOW. Seriously, finish this post, fund a savings or investment account and go chest-bump a stranger to celebrate.

Saving early takes advantage of a concept called the time value of money. Time value of money basically means “a dollar today is worth more than a dollar tomorrow.” Why? Consider the following example:

Congratulations! You had a lapse in judgment, bought a scratch-off lottery ticket (don’t get me started on these) and won $1,000!! You have two payment options: A. Take the $1,000 payment now, or B. Take the $1,000 payment in exactly one year. Which option do you choose?

You should chose option A, but why? Two reasons: (1) inflation and (2) investment opportunities.

Since the US government began tracking consumer prices in 1913, inflation for the US dollar has averaged slightly higher than 3% per year. In other words, each dollar you own, on average, becomes 3% less valuable each year. This is why receiving the same salary as last year is not a good thing. Depending on what inflation is for the year, you should ask your boss for a raise at least as high as inflation for the year in order to avoid making less based on the purchasing power of your money.

Time also provides you the opportunity to invest and receive a return on your investment. Burying your money in your backyard, while potentially protecting you from the risk of losing any money, provides a negative return on investment due to the effects of inflation (and probably creeps your neighbors out in the process). Even if the money manages to survive in your backyard, it will have lost value over time due to inflation. Rather, depending on your preferred level of risk, you could invest your money in a vast array of investment opportunities in order to receive a positive return on investment above the rate of inflation. Over the past century, investments have averaged roughly the following rates of return before inflation:

*Note these are approximate averages for informational purposes. These returns are not applicable for every economy or decade.

Note that all the average rates of return in the chart above are higher than the average rate of inflation of slightly higher than 3% per year. Investments provide you the opportunity to increase your investment over time. It’s important to note that these rates of return are not guarantees. The value of all of these investments fluctuates up and down, and every investment has a risk of loss. However, as evidenced by the chart above, your level of risk is rewarded with higher average returns over the long-term. These returns, assuming you have the patience to ride market fluctuations for the long-term, will allow you to grow your money well beyond the drawback of inflation.

Compound Growth (Interest)

Compound growth should be your best friend. Next time you see your real best friend, tell him/her you have a new best friend named Compound Growth. Okay don’t do that. But seriously, compound growth is the smartest and easiest way to grow your wealth.

What is compound growth? It’s earning money on your earnings. For example, say you invested $100 in a savings account one year ago and it earned $5 in interest last year. This year, you’ll be earning interest on $105 (original $100 plus the $5 in interest). While this may not seem significant, over time your investment would grow exponentially. Understanding this simple concept is very important to your financial success.

Time value of money is the basis behind compound growth. The earlier you invest, the more years you have to earn a return on your original investment AND earnings. Whether your earnings represent interest on interest from savings or dividends/capital gains on dividends/capital gains from stock, this concept assumes you reinvest the earnings you receive. To illustrate, consider the following example:

Say you put $1,000 into an IRA at the beginning of each year from age 18 to 30 (13 years) and then never add another dime to the account after age 30. Assuming the account earns 7% each year, you would have over $215,000 in the account when you retire at age 65. A friend of yours doesn’t start until age 30, but saves the same amount ($1,000) per year for 35 years straight (22 more years of saving than you). Despite putting in almost three times as much money, your friend’s account does not even reach $148,000.

This shows the power of time in investing. The three components of compound growth are (1) the amount you invest, (2) the earlier in life you invest and (3) the rate of return you earn on your investment. The more you invest, the earlier you invest and the higher the rate of return on your investment, the more money you will have later. While the third component can be less certain, you control the amount and timing of your investment. To emphasize a point made earlier (you will hear this again and again), the more you save and invest earlier, the easier it will be to achieve your financial goals.

Compound growth is the reason your grandparents bought you that savings bond you hated when you were a child. You wanted toys, but your grandparents got you something seemingly even worse than clothes. But your grandparents are old and wise. You can thank them now for how large that gift will be when it matures.

Benjamin Franklin had this wisdom as well. Most of us know the face of our $100 bill as a great Founding Father, diplomat, scientist, inventor and writer; however, few people know about Franklin’s expertise in compound growth. When Benjamin Franklin died in 1790, he left a gift of £1,000 (approximately $4,400 at the time) to each of the cities of Boston and Philadelphia. Under the terms of the gifts, the money was to be invested and could be paid out at two specific dates, 100 years and 200 years after the date of the gift. After 100 years, each city was allowed to withdraw a portion of the money for public works projects. In 1990, 200 years following the date of the gift, Philadelphia’s trust was worth $2 million and Boston’s was worth $5 million. Now that’s quite the return on investment.

Franklin himself liked to describe the benefits of compounding, “Money makes money. And the money that money makes, makes money.” Even Albert Einstein cherished compound interest, saying, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” Albert Einstein also discovered the “Rule of 72,” which is worth understanding:

Rule of 72

To determine how long it will take to double your money (or your debt) at a given interest rate, divide the number 72 by the interest rate you are receiving. The resulting value is the approximate number of years it will take to double your money. For instance, if an investment is earning interest of 3% per year, the money will double in approximately 24 years (72 / 3 = 24).

You don’t have to be as smart as Franklin or Einstein to take advantage of compound growth, and the principle works the same regardless the size of your investment. It just takes initiative and discipline on your part to invest as early and as much as possible to take advantage of this phenomenon. However, it’s important to note compound growth is a double-edged sword: the same rule applies to your debt. Whereas time is on your side in investing, it’s your enemy when you are in debt: simply paying the minimum payments on your credit cards will likely keep you in debt forever. This once again emphasizes the importance of paying off your debt as soon as you establish that small emergency fund.

You’ll find that investing requires you to sacrifice some today to reward yourself greatly in the future. I (and more importantly, Benjamin Franklin and Albert Einstein) promise you the future rewards will greatly outweigh the current sacrifice.