Time value of money

The most basic law in finance! The time value of money states that a dollar today is worth more than a dollar at some time in the future. Okay, it’s not that simple to understand at first glance so let me delve into this advice a little with some financial examples:

If I invest $1,000 in a 5% savings account today, it will be worth $1,050 in one year. Therefore, if I can have $1,000 today or choose to have $1,000 one year from now, it is always better to have the money now. By saving and investing today, you make the time value of money work for you.

Let’s look at the reverse of this, to see how the time value of money can work against you. Suppose instead of receiving $1,000 that you spent $1,000 by purchasing merchandise on your credit card. Remember that a dollar today is worth more than a dollar tomorrow, so in this case, you will have lost money because you will need to pay off your credit card account with money from the future (which is worth less than money today). In addition to having to pay with future money, you will also have to pay interest expense. So, in this case, if you paid off the credit card in one year (assuming 15% interest), you’d have to pay $1,150.

You should think about the time value of money before making any decisions. Another, maybe even more important concept related to the time value of money is the compounding effect of money.

Oportunity cost

Opportunity cost is defined as the cost of pursuing one alternative versus another. For example, if you were going to spend $500 on a new bike, the opportunity cost would be that you would not be able to buy anything else with or invest that $500. For the purposes of financial planning, you should look at the cost versus the benefit of each decision you make. In this case, you could spend $500 on the bike or you could invest the same $500 in a savings account. In five years, the bike will be worth $25 and the $500 investment will be worth $650 (including interest). The opportunity cost of buying a bike is the long-term benefit that you will receive if you did not buy the bike and invested it. Technically, the opportunity cost is not limited to the cost of investing the money, but also includes any other opportunity you could spend the money on (investing, buying something else, saving the money, etc). By carefully evaluating your alternatives and by weighing the opportunity cost of each decision, you can vastly increase your long-term wealth.

First rule: don't spend everything you earn

The most important way to generate wealth is to live within or below your means. For example, if you make $30,000 a year, then live like you make $25,000 a year and save, pay down debt, or invest the remaining $5,000. So many of my friends that have incomes over $50,000, $75,000 and even $150,000 have spent everything they’ve earned and have almost nothing to show for it. Don’t try to compete with your friends or neighbors, don’t spend money fruitlessly, and most importantly, don’t spend more than you make. Many people read this and think, “I’d love to spend less money but I can’t, I have to pay my car payment, the credit card bills, groceries, I need a vacation, I need new clothes for work, etc, etc.” Most of these expenses could be avoided or deferred (like a vacation, a car purchase or buying clothes). The other expenses (like your credit card expenses or mortgage) could likely have been avoided if you had lived within your means when you created the expense. For example, your car payment would be less if you’d opted for the used versus new car, or your credit card expenses would be lower if you hadn’t bought that new computer or those 5 pairs of shoes. Even your mortgage or rent could be less if you chose a different location to live. With that said, there is a fine line between spending appropriately and spending above your means. Just remember that it is always better to forego purchases until you can pay for them in cash rather than to borrow from the future to meet your needs now. The most common exception to this rule is buying a house. Although it will raise your cash expenses dramatically, it is often wise because 1) it’s an investment which will add to your future net worth, 2) the interest is tax deductible which effectively lowers your income tax liability, 3) your mortgage payments will add to your net worth as you pay down the principal on the loan, and 4) you were probably paying rent anyway so it will in effect turn your rent payment into an investment.

Stocks vs. bonds

Are you as tired as I am of hearing about what percentage of your portfolio should be in bonds? It seems like lately there has been a plethora of articles outlining guidelines and suggestions on the allocation of stocks vs. bonds, especially in the wake of a huge focus on relatively new Target Retirement Date funds. These funds allocate your portfolio between stocks and bonds based on your estimated retirement date.

First of all, every investor has a unique time horizen and risk tolerance, so any rule of thumb is hardly adequate. Secondly, I think the typical rules of thumb are too conservative anyway. Many people are now living well into their 90s–and a recent article in Time suggests that some women in their 20s today may live to be over 120. Additionally, careers and aspirations are changing. Few folks can or want to quit earning income and live totally off of their retirement funds at 65.

So the method of “subtract your age from 100″ or even from 115 to get the percentage of your portfolio that should be in bonds seems rather outdated. Target Retirement Date funds that allocate half of a middle aged person’s portfolio to bonds can actually be much too conservative, especially if that person has significant short-term assets outside of their retirement portfolio or if they expect to have other sources of income past age 65 such as pensions, passive income, earned income, or social security.

And yet funds that allocate smaller percentages to bonds are labled “aggressive” or even “very aggressive” which can confuse and scare away investors who wouldn’t categorize themselves with those lables. Words like “balanced” describe funds with upwards of 35% in bonds–which can actually be very conservative if you’re investing for the long haul.

I’m also particularly tired of all the articles that seem to come out of the woodwork when the market is “unstable” which ask, imply, or suggest that one should shift a larger percentage of their portfolio to bonds. Just yesterday a commenter suggested that I shift a third of my stock holdings into bonds.

Last time I checked, selling stocks when the market goes down is NOT the best way to maximize your return. Isn’t “buy low, sell high” supposed to be the goal? Besides, your allocation decision shouldn’t have anything to do with what’s going on in the market in the short term. Or perhaps I just missed the memo announcing that the media has suddenly gotten really good at predicting the market.

Personally, I don’t think ANY significant percentage of my retirement portfolio should be in bonds. I have almost 4 decades before I am legally supposed to touch my 401k or IRA. And even then, I plan to have enough “passive” income to keep me from having to totally live off my retirement funds. Plus, basically all of my non-retirement funds are in cash or bonds.

What’s your view on the stocks vs. bonds debate? What factors should determine your asset allocation?