Time Value of Money
If you have read a few of my blog posts, you have probably come across the idea of early investing. It’s an amazingly efficient way to go thanks to the time value of money.
The time value of money refers to the idea that $1 today is worth more than $1 tomorrow. One example we have all felt lately is inflation. A gallon of gasoline and a cart of groceries cost more today than 30 years ago. The same could be said for many other goods and investments.
There is a formula for time value using the following factors:
FV – Future Value of Money
PV – Present Value of Money
r – Interest Rate
t – Time
FV = PV * (1 + r)t
Note how interest rate and time are the biggest drivers of this equation. This equation works in your favor when you have a respectable rate of return and time on your side i.e. compounding interest. This equation inhibits wealth building when you spend too much time paying interest and/or losing to inflation.
Opportunity cost:
These are the true costs plus the foregone benefits of an action. For example, the opportunity cost for me as an RN returning to CRNA school was 3 years and $550,000. 3 Years of anesthesia specific training. $150,000 of school specific costs. $400,000 of missed travel nursing wages over 3 years.
Fast forward a few years…
I have an upcoming getaway with a price tag of $6,000 for the family. True cost -- $6,000.
The time commitment is 9 days. This requires a weekend, a full week, and the trailing weekend away from work. As an independent contractor, time away has a cost of missed wages.
I conservatively estimate $6,000 in true costs PLUS $15,000 in missed wages -- $21,000. But wait… I would have invested that money, say 2/3 of it after living expenses and taxes. I would have contributed $14,000 to the brokerage account looking for an 8% annual return.
30 years from now, that $14,000 would have grown to $140,000 in my brokerage account. Accounting for 3% inflation, that $140,000 compounded return would have the buying power of $60,000 in today’s dollars.
Foregoing a vacation and working 1 week could be traded for Mrs. TFC’s 4 Runner.
8% Annualized Return on $14,000
Here is why my opportunity cost for attending this event is so high.
My earning potential is high. If I earn $1,000 per week, the missed wages would be far lower.
I would actually invest the money. As a traveling locum, I basically invest basically everything I earn. I have zero doubt about trading income for VTI or VUG. An 8% annual return is reasonable.
I know I would be working. I love working. I worked 50 weeks and 25 weekends last year, so I can safely assume I would work that week, plus one of the weekends. It’s not like me to sit around on a week off.
It’s dangerous to treat all decisions like this otherwise there would never be time away from work. Never a vacation. Never a discretionary purchase. Not great for longevity or mental health. I speak about opportunity cost as a way to compare the time value of money components.
Life isn’t about never spending money or never taking a vacation, but rather understanding opportunity cost. A concept that greatly influences ascension of the socioeconomic ladder. More folks need assistance saving versus spending. If someone needs help spending, it isn’t too tough to burn $500k per year.
Let’s flip the script:
When I was looking for jobs as an SRNA, I assumed 5 weeks of PTO to be used as vacation. The remaining weeks I would look for locum work. A job offering 8 weeks PTO meant 3 weeks of locum coverage for the year. I added the expected locum earnings to the total expected compensation for a given job.
Assuming a market rate of $200 per hour and 40 hours per week, I could reasonably expect a casual locum gig to gross $8,000 per week. That’s an extra $24,000 per year. This would increase the average W-2 CRNA’s income by 10% and still leave 5 weeks PTO to enjoy.
This $24,000 could go towards paying down debt, funding tax-advantaged accounts, or any number of actions.
Every shift results in $1,600 gross wages. Assuming $1,000 of net income invested into VTI, at age 30, that single shift’s investment would grow to $14,785 at age 65. Accounting for inflation, each shift has the buying power of $5,500 today. When trying to get ahead financially, would you work an extra shift for $5,500 of buying power?
That’s a total of $82,500 of BUYING POWER for working 3 extra weeks. 15 extra days. It doesn’t take much effort to have a massive impact. A few extra shifts here or there. A couple more shares of VTI throughout the year. That’s opportunity cost. That’s the moneymoon.
Like before, FV decreases with a shorter timeline and less discipline. All the more reason to be disciplined and frontload effort. As you age, it’s the same work, but with significantly different FV due to fewer years of compounding effects.
Work efficiently by tapering the workload. Consider working 47+ weeks per year through your 30’s to work 26 weeks per year through your 50’s. Fewer weeks worked over the career with the same earnings (if not more) compared to working 44 weeks annually for 30 years.
Inflation:
Inflation averages 3% annually. If your investment returns are not outpacing inflation, you are losing buying power. That’s why it’s important to invest in assets. Generate a return exceeding inflation.
When transferring capital into investment accounts, be sure to invest the dollars into an asset. Something like VTI, VOO, VUG or the similar. Any broad market index fund will do. If not invested, funds will likely sit in a money market account earning a return similar to the rate to borrow money, which currently hovers around 4%.
The saying, “cash is king” refers to cashflow and the ability to buy assets at a discounted price. It does not encourage the use of buried treasure chests as an investment vehicle.
Speaking of vehicles, it’s important to avoid too many depreciating assets. Buying a vehicle ties up cash that could be used to invest. The vehicle then depreciates over time. A new vehicle depreciates 60% over the first 5 years.
If there was a loan on the vehicle, you are then paying a fee to own something going down in value. Not a great look from an investing standpoint.
In most situations, vehicles are necessary. $120,000 vehicles for personal use are rarely necessary. Spend reasonably in the “depreciating assets” category until some degree of financial stability arrives. See the above table if you need a reminder of opportunity cost.
Borrowed Money:
I’m generally averse to personal debt, but for those of you with a mortgage of 3%, that’s a deal. That’s a deal because a 30-year fixed rate mortgage at 2.5% is historically less than the rate of inflation. It’s mathematically advantageous to hold the mortgage because your buying power increases over the duration of the mortgage. Inflation matches or outpaces your mortgage interest rate.
The same can be said for deferred interest. A $2,000 payment today is more expensive then a $2,000 payment next year. I’m cautious with holding deferred interest loans because when the interest kicks in, the rate will probably be 8%. Or 25% with credit cards.
Don’t squander funds that could have paid off a loan with deferred interest only to get burnt on the back end of the loan.
If debt averse or in doubt, just pay off personal debt.
Balance:
Working every day of every year isn’t a healthy approach. It’s important to live life. It’s important to enjoy your earnings. All I’m asking is for you to consider the financial opportunity cost and consider the time value of money.
If your will to work or invest is lower, your opportunity cost is lower. If earnings from overtime go towards discretionary purchases, you opportunity cost is lower. Know your opportunity cost for different actions.
The TFC approach:
Frontload effort by earning AND INVESTING big dollars through your 30s. Have FV work in your favor. After building a respectable investment portfolio and achieving financial independence (FI), there is no need for earned income. This means there is no realized opportunity cost for taking time away from work. There is no realized cost for spending instead of investing. This is the real deal.
It’s a matter achieving FI. Easier said than done. Feeling stuck on your FI journey? We offer coaching and an online course. Best of luck! I know you will get there.
Thanks for reading.
