Updated: Mar 10
An unfortunate but often true saying is:
“The time value of money benefits the young, but the young don’t appreciate the time value of money.”
Discipline and self-awareness enable making the most of the time value of money. The discipline of regular savings makes a tremendous difference in your life, especially if you start when you are young. Not to say, saving does not benefit older people, but as demonstrated below, the time value of money accrues to the young by a significant margin.
The following chart shows the saving and investing benefit over time. For this example, there are two fearless savers, Aaron and Alisha. Aaron starts saving at 50 and Alisha starts saving at 22. (At the bottom of this article, please find the author's "Investing For Retirement" excel model to run your own simulation.)
You can find yourself on this chart by subtracting your current age from your desired retirement age. Find this number on the horizontal axis, then follow this number vertically to the blue and orange lines. Compare these 2 points. The blue line point is the money you contribute, the orange line point is the money you are projected to receive in the future. See below for the other assumptions.
Blue line - savings contribution Orange line - investment value of savings
The assumptions are:
7% Long Term Tax adjusted rate of return
$500 Monthly Savings
2% Annual savings increase
Retire at 67
For “delay saving” Aaron, at retirement, will have contributed $118k and the investment will grow to $221k. Not too bad, he made over $100k for retirement. But now let’s compare this to “super saver” Alisha. Because she will save longer, Alisha will contribute more than Aaron. The super saver’s savings contribution is $389k at retirement. However, due to the wonder of compound interest and habitual savings, Alisha’s total retirement savings balance is $2.4 million! Another way to look at it is that Aaron made an 87% gain on their money, while Alisha made 517%. The difference is time. Be like a super saver Alisha - let time work for you!
Think of this curve in terms of optionality. While it takes time to build wealth as an option, once you do, it will significantly increase your personal degrees of freedom. Also, it is a self-reinforcing causal loop. This means, once your savings and investing get to an inflection point, the wealth feeds on itself and doesn't require as much contribution maintenance.
Think of the inflection point as pushing a bike to the top of a hill. You had to work really hard to get your bike to the inflection point, but once over the hill, it is fun to go fast downhill!
Once past the inflection point and going downhill, you can use that money as a personal security foundation, but then use the remainder to increase your own consumption, to help family members or other loved ones, to build businesses, or whatever.
This is an example of the time value of money at work. It is also an example of a general class of exponential growth functions called Power Laws. A quote that comes to mind is:
“The greatest shortcomings of the human race is our inability to understand the exponential function.”
- Albert Allen Bartlett
Why don’t younger people always appreciate the optionality curve, the time value of money, or power laws in general? There are a number of reasons, but I suspect some of the factors are:
Lack of financial education
Lack of investment tool access
Lack of budgeting or overspending
Natural cognitive biases [i] impacting saving and investing, such as:
Exponential Growth Bias - people generally underestimate exponential growth
Time Discounting Bias - preferring immediate gratification over long-term financial goals
Procrastination Bias - delay in completing an important task
Salience Bias - over-weighting immediate, easy-to-perceive information at the expense of under-weighting longer-term, harder-to-perceive information
There are many other cognitive biases. Eric Johnson is a decision scientist at the University of Columbia. Dr. Johnson does empirical research on the challenge of savings. [ii] He said:
“Underestimating the effect of compounding has a very real effect on both saving and borrowing. It makes saving look less attractive, because we underestimate what we will receive at the end of our investment.”
The other reality is, the prefrontal cortex, where executive functioning occurs, is not fully mature until well into our 20s. Executive functioning is part of our brain that makes us do stuff our cognitive biases may otherwise hide from view. This means cognitive biases are even more difficult to manage when many people are setting their saving habits. Sadly, our own biology is working against us. The point is, the more you understand how your brain is wired and the obstacles that may arise to sound financial planning, the better equipped you are to overcome them. Another way to look at it is, sound financial planning is not intrinsically difficult. The challenge relates to cognitive biases and the way our brain functions.
Finally, there are also cultural factors at play. While human cognitive biases affect all people, certain countries tend to create a cultural environment less suited for the long-term thinking associated with the time value of money. According to an ongoing, long-term longitudinal global study, the U.S. culture is generally geared toward short-term thinking. [iii] Among other cultural characteristics, Americans tend to be impatient, having a "time is money" cultural attitude heavily weighted to today. This American cultural short-termism is certainly counter to driving long-term wealth associated with the time value of money.
The good news is, creating savings and investing habits may be accomplished without understanding the time value of money or without becoming a cultural victim of short-term thinking. The habit of saving is so very important to long-term financial health. Maximize tax-advantaged participation in your company 401k plan or contribute to an IRA. Also, many companies' 401k plans match employee contributions. So they are paying you to save! Beyond tax-advantaged savings, you may contribute money after tax. Every little bit helps. Start small and build. In terms of tools, many companies have good programs to help you through the investment selection process. If not, robo-advisors are excellent fintech enable platforms for investing. They are very easy, intuitive, and educational.
Most important is...just do it. Get in the habit. Create self-activating commitment devices. You may do this via automatic payroll distributions or checking account transfers. If saving is automatic, then you will hardly miss it. From an attitude standpoint, live by the standard “Pay myself first.” Meaning, my other life expenditures are based on what is left over after I have paid myself. If you wait to pay yourself until after all your other expenditures are paid, there may not be anything left over.
Finally, it is never too late to start. You may be older than super saver Alisha. That is ok! Even in the case of Aaron, saving and investing are beneficial. A helpful attitude is “Progress, not perfection.”
“Pay myself first” is a beneficial mindset. You’ve got this!
[i] Jeff Smith, VP at Self https://www.self.inc/blog/cognitive-biases-that-impact-our-finances
[ii] Johnson, The Elements of Choice: Why the Way We Decide Matters, 2021
[iii] The cultural analysis is from Hofstede Insights. The data source includes the World Value Survey. As of 9/21/21, the U.S. has a long-term orientation index of 26. Germany and China are indexed at above 83, more than 3 times higher than the U.S. This suggests Americans are at a cultural disadvantage when building long-term wealth habits.
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