Sunday, May 15, 2011

Time value of money

Most of us understand the time value of money, and many of us learn this concept within the context of money saved. If you put $1,000 into a savings account now, you’ll have $3,000 in 30 years.

And so we save for retirement with the assumption that our investments will earn money for us; if we want to retire with a million dollars, we really save less than half that over the course of our careers.

And yet, when we purchase something, the dollar amount often escapes this same “time value” scrutiny. We understand what our “saved” dollars are worth twenty years from now, but we fail to calculate what the future value is of our “spent” dollars. And if each dollar can only be used once – for either savings or spending – it behooves us to compare them within the same “future value” context. What amount are we really depleting from our future retirement account by spending a dollar now?

So, at inflation alone (which is less than you’d feasibly be earning in an investment account)….
That $4 daily coffee? In forty years, it could have been an additional $20 in your retirement.
Get one every day? You’ve elected to have $7,000 less in your retirement account.
The $20 lawn ornament? It could have been another $100 in retirement.
Oh yea, and that $500 iPad? It depleted $2,000 from your retirement.
How about if you want a nicer car and increase your payment by just $100 a month?
(That can’t hurt, right? I can afford it.)
Over the course of forty years, that’s $114,000 less in your retirement account.

I know what some of you are thinking: I’ll have a million dollars in retirement. What do I care about an extra $100? Or maybe you’re thinking: I already saved my obligatory 10% this month. I deserve that lawn ornament!

And it’s a valid point. My response to it is: consider which will make you happier. Imagine you’re traveling in Europe with your spouse in retirement; that extra $100 could mean the difference between one of the most spectacular meals of your life or another night of 2-euro slices of pizza in Italy. But you’re right – maybe that lawn ornament does make you happier. You can certainly take comfort in that fact as you’re wolfing your pizza together, huddled under an awning on the cobblestone street, wondering what else to do with your week in Italy without spending the money you already spent.

related WSJ article:

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