Sunday, January 23, 2011

What is the Most Important Factor in the Wealth Equation?

In Football there are many different players on a team. But, if you ask people who the most important player on the team is, most people would probably say that it is the Quarterback. I don’t have any proof that this is the correct answer and some people may debate this answer, but I am just reporting to you what most people would say if asked that question.

Okay, so maybe the game of Football is not my strong suit, but one thing that I do know is the "Money Game". And in the "Money Game", there is a Wealth Equation. Unlike Football, the Wealth Equation has only three players – Money, Interest Rate and Time. Usually when I ask anyone what they think the most important factor of the Wealth Equation is, I usually get, “Duh, Money of course is the most important! Then Interest Rate and then finally Time.”

But unlike in Football, I am sure what the most important factor in the Wealth Equation is. And, as a matter of fact, I even have proof to back it up. Despite what most people would say, Money is not the most important factor. The most important factor in the Wealth Equation is Time. In fact, if you were to order them by their importance it would be Time followed by Interest Rate then Money.

I am not trying to give you a math lesson here, but I can’t think of an easier way to prove the importance of Time in the Wealth Equation without actually showing you the equation! Because of financial calculators and other financial applications, most people don’t even know what the Wealth Equation looks like. I, however, believe that it is important to at least see the equation and identify all of the players, so you can understand what is going on in the background after you enter your numbers and press the “Submit” button. Here are two different scenarios of the Wealth Equation:

The One-Time Payment Wealth Equation figures out the Future Value (FV) or the Wealth you would earn from investing a one-time sum of Money and leaving it alone to grow at a certain Interest Rate over a certain period of Time. In this equation, PV stands for Present Value and this represents Money, i represents the Interest Rate and N represents Time.
The Periodic Payments Wealth Equation figures out the Future Value (FV) or the Wealth you would earn from investing a sum of Money over a certain frequency of Time (i.e. monthly, bi-annually, or annually) at a certain Interest Rate over a certain period of Time. In this equation Pmt represents Money, i represents Interest Rate and N represents Time.
Even if you don’t remember anything about Algebra, I'm sure you probably at least remember which variable in the above equations carries the most weight. If you are thinking the variable N then you are correct. The N carries the most weight because N (Time) is exponential.

The Wealth Equation Factors in the Order of Importance:

3.) MONEY, believe it or not, is the least important factor in the Wealth Equation, because Money is linear. Meaning, for example, if you double the Money and leave the Interest Rate and Time the same, then the results will double too. It's a one-to-one relationship
  • $2,000.00 @ 8% for 30 years --> $20,125.31
  • $4,000.00 @ 8% for 30 years --> $40,250.62 By doubling the Money from $2,000.00 to $4,000, the growth is $20,125.31 which is double.
  • $8,000.00 @ 8% for 30 years --> $80,501.24 By doubling the Money from $4,000.00 to $8,000, the growth is $40,250.62 which is still only double!
2.) INTEREST RATE is the next important factor in the Wealth Equation. If you take the same Time and Money and keep doubling the Interest Rate, you can see that the changes in growth are not linear.
  • $2,000.00 @ 2% for 30 years --> $3,622.72
  • $2,000.00 @ 4% for 30 years --> $6,486.80 By doubling the Interest Rate from 2% to 4%, the growth is $2,864.08.
  • $2,000.00 @ 8% for 30 years --> $20,125.31 By doubling the Interest Rate from 4% to 8%, the growth is $13,638.51!
Here's a great article demonstrating the importance of the Interest Rate in the Wealth Equation:
1.) TIME is the most important factor in the Wealth Equation. If you take the same Money and Interest Rate and keep doubling the Time, you can really see the exponential growth.
  • $2,000.00 @ 8% for 10 years --> $4,317.85
  • $2,000.00 @ 8% for 20 years --> $9,321.91 By doubling the Time from 10 to 20 years, the growth is $5,004.06.
  • $2,000.00 @ 8% for 40 years --> $43,449.04 By doubling the Time from 20 to 40 years, the growth is $34,127.13!
Here are some other relevant articles that stress and further explain the importance of Time in the Wealth Equation:

So, now that you understand how important Time is in the Wealth Equation I hope you are inspired to stop procrastinating and start investing for your future as soon as possible, if you haven’t already. And I hope that you in turn pass on the knowledge of the importance of investing as soon as possible to others too.

I'm so excited to share this information with you. If you have enjoyed the information or feel that it would benefit someone else, please share it. If you have any questions or comments, please feel free to contact me.
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