Sunday, April 7, 2013

Show Them the Prize (and Penalties) and They Will Gladly Pay the Price

I believe the most important financial lesson that everyone needs to learn as early as possible in their life is the understanding of the time value of money.

For example, let's just say that a 27 year old named Bob started investing $100 a month and wanted to do this for 40 years until he was 67. If that money was working at a 9% interest rate he would have accumulated $471,640 by retirement. In this case the price was $100 a month for 40 years and the prize was $471,640 in retirement.

Now, lets suppose Bob decided that it was more important to save that $100 a month towards something else like a big screen television and that he will start investing next year at age 28. So, by waiting a year to invest he is saving himself $1200 right? Let's see, by investing $100 a month at age 28 for 39 years, because now he has one year less to invest until age 67, working at 9% he would accumulate $430,040 or $41,600 less than his initial prize by retirement. So really this is not a savings of $1200 - he has a nice new flat screen television, but has paid a hefty penalty of taking $41,600 away from his retirement money, all for waiting just one year to start investing.

Like most people who procrastinate for one year, that one year turns into 5 years. So, if Bob were to wait 5 years until the age of 32 to start investing, he would have technically saved himself $6000 by not putting away $100 a month for 5 years. However, by age 67, that money working at 9% for only 35 years would have grown to $296,380, which is really a penalty of $175,260 to his retirement savings.

Before he realizes it, 15 years go by and at 42 Bob still hasn't started investing. He now realizes that by not investing that $100 a month for 15 years he was able to spend an extra $18,000 during that period, however, he really doesn't have much to show for all of that extra spending. He also now realizes that if he were to start investing $100 a month for only 25 years at 9%, he would accumulate $112,950 by age 65 which would be $358,690 less than what he would have accumulated had he started back at age 27. Bob knows that he is not going to be able to retire on just $112,950. At this point Bob meets with his financial professional and learns that if he wants to reach the goal of his original prize - $471,640 - by age 67 he would have to raise his monthly investment by over 4 times - from $100 a month to $418 a month - and he will have to continue this for the 25 years until he turns 67.

So, at age 42, Bob learns some very important lessons on the time value of money and some of the penalties that can incur - like getting smaller prize or paying a higher price - by just waiting to invest.

By learning the time value of money earlier in life we can teach better lessons - like how to increase the prize or how to lower the price of the prize. Let's see what would happen if Bob were to understand the time value of money at age 18, 9 years earlier than he originally started thinking about investing:

How to increase the prize
Let's say Bob had a job and could afford to invest $100 a month (that's only about $25 a week) at age 18. If he were to do that, he would have 49 years until he was 67 and if it was working at 9% that would accumulate to over $1 million ($1,073,683 to be exact)! Over doubling the initial prize by starting to invest only 9 years earlier - not a bad deal!

How to lower the price
Suppose Bob couldn't afford to invest $100 a month, but he still understood the time value of money and his goal was to reach the initial prize of $471,640 by age 67. By starting to invest 9 years early, Bob would only have to invest $44 a month, less than half the amount he would have to invest had he started when he was 27.

I hope by now you agree with me on the importance of understanding the time value of money. I actually believe that this needs to be taught before the age of 18 - as early as they can comprehend - and that it needs to be reinforced continually over the years. I realize how tough it is to teach kids to invest at an early age - I have two young ones myself. However, if we show them the prize and how they can avoid the penalties, they will gladly pay the price!

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 comments, please post them below, otherwise, feel free to contact me.
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