The time value of money is the concept that a dollar today is worth more than a dollar next month, next year, or ten years from now. This makes sense because you can invest a dollar you have today in an interest-bearing account and it will be worth more in the future. Compounding, which is earning a return on your interest, in addition to your principal, helps to accelerate the growth of your investment over time. However, a dollar today is only worth more than a future dollar if you put it to work. If you bury your cash in the backyard, it will lose value over time due to inflation. In order to capture the time value of money, you have to invest your dollars.
Unfortunately, when it comes to investing, people seem to forget about the time value of money, often choosing to sit on their cash waiting for the right time to invest. The explanation for this behavior is that stock market returns are not as predictable as most interest-bearing accounts. Since stock returns can be volatile, why not wait for a market downturn to invest your assets? Unfortunately, academic evidence suggests that you cannot accurately predict the next market downturn and the expected stock market return is positive at any given point in time, regardless of what the market has done in the recent past. The stock market is priced to provide investors an equity risk premium at all times, so the expected future return is always positive. This does not guarantee that stocks will go up over any given time interval, however. The market adjusts quickly to new information and can spike up or down without warning as this information becomes available. Nevertheless, over the long run, you should capture higher returns by investing your liquid assets sooner rather than later.
Your window for contributing to an IRA or Roth IRA extends from January 1 of the contribution year until mid-April of the following year. To maximize your expected returns, these contributions should be made as early as possible. The strategy of investing early can also be implemented in some 401(k) or 403(b) accounts. If your 401(k) plan allows you to make your entire annual contribution in early January, rather than later in the year, you should opt for the early deposit, if possible. This strategy does not pay off every year, but is almost certain to provide higher returns over the long run.
What about dollar cost averaging? This involves investing a fixed dollar amount on a regular schedule. It is a great strategy if you start with no extra money, but with the ability to make future deposits. Setting up automatic monthly deposits into your investment account is one of the best ways to build your savings over time, and is highly recommended! What if you receive a large one-time windfall, such as an inheritance or insurance payout? The appeal of dollar cost averaging in this setting is that you avoid the risk of a huge drop in the market occurring immediately after you’ve invested your lump sum. While this makes intuitive sense, it does not hold up to rigorous scrutiny. Dollar cost averaging in this setting has been shown in academic studies to be a flawed strategy. An immediate lump sum investment not only provides a higher expected return, but does so with slightly less risk. If you are sitting on a pile of cash, my advice is to follow the superior strategy and invest it right away. If the psychological lure of dollar cost averaging is too great, it is best to use a short time interval between deposits (e.g., monthly) and a relatively short overall time horizon.
Our mission at Shearwater Capital is to take the best ideas from the world of academic finance and apply them in a practical manner to personal investing and portfolio management. Investing early and often is a great way to harness the power of compound returns and the time value of money.
As always, please feel free to contact me with any questions or comments.
Jeffrey J. Brown, MD CFA
Principal, Shearwater Capital