Understanding the Time Value of Money
The most underrated contributing factor to wealth creation.
In his book The Psychology of Money, Morgan Housel dedicates a chapter to compounding. He explains that the human mind struggles to comprehend the power of compounding over time and we rarely stop to consider its impact.
He shares some mind-boggling stats on Warren Buffett’s wealth creation:
At the age of 89, Buffett had a net worth of $84.5B
Of that, $84.2B was acquired after his 50th birthday
$81.2B came after he qualified for retirement benefits in his mid-60s
Consider this:
Buffett started investing at the age of 11
By 30, his net worth was $1m (or $9,3m adjusted for inflation)
What if he had been more of a “normal person”, spending his teens and 20s exploring the world and finding his passion, and by age 30 had a net worth of $25’000? Let's also assume that up to the age of 60, he earned the extraordinary annual returns he’s been able to generate (22% annually) and then retired at 60 and stopped investing.
What would he be worth today? $11.9 MILLION.
99.9% less than his actual net worth.*
Buffett's success is not only attributable to his exceptional investing abilities but also to the fact that he has been a phenomenal investor for THREE QUARTERS of a CENTURY.
Don’t brush this off as a story too far-fetched to relate to.
If we tone down the numbers and calculate three scenarios of investors investing for retirement, each investing $500 per month at a 5% annualized return, but starting 10 years apart:
Each 10-year gap results in an almost halving of the retirement value.
If $500 a month seems too high, this is what the same three scenarios look like if the monthly investment amount is $200, all else equal:
Same impact. A 10-year waiting period almost halves the investment value.
You can make the time value of money count in your favour by investing as often and as early as possible. The earlier the better, but frequency also matters. By making monthly investments of $500 instead of annual investments of $6’000 ($500*12), the result is an extra $21’765 by retirement:
In my experience, everyone is still out there looking for a quick win. They ask which stocks to pick in the hope of making a quick return. They never ask how often and how long they should invest for. They ignore the compounding impact of money.
By ignoring the compounding impact of money, we attempt to achieve wealth creation by aiming for the highest investment returns.
Creating wealth is about achieving decent returns for the longest period possible, because the highest returns tend to be once-off hits.
The money you have right now is at its most valuable, since it has the most compounding potential. By harnessing the power of the time value of money, you can start to build wealth.
Be a Saving Susan:
Source: Psychology of Money by Morgan Housel.
Calculations: My own.