One of the first things you learn in business school (or any finance class) is how to calculate present value (PV). This exercise involves determining the current value of an amount of money in the future, considering such factors as time and discount rate.
Yeah, you might not get too excited about this definition and your eyes may glaze over at the mere thought of the behind-the-scenes calculation involved to get to a present value number. But if you’ve ever had to decide if you should accept a cash rebate, opt for 0% financing, or pay points on a mortgage, you’ve actually done a present value calculation!
As such, you’ve demonstrated an understanding of a core theory of finance: the time value of money.
Understanding the present vs. future value of money is one thing; making choices that honor this financial principle is quite another.
For evidence, exclude capital appreciation and just look at your contributions to your savings accounts (including retirement accounts). What you see is proof that you bump up against this clash between financial theory and human behavior all the time.
As we approach the (almost) half-way mark in the year, how are you doing with your savings? Are you right where you thought you’d be by now or far from it? Do you have a short distance to travel to reach your year-end goal, or is there a long-haul still ahead for you?
Circumstances certainly play a role however you answer the above questions. But so do your choices and behavior.
If you know a dollar today is worth more than a dollar a year from now; if you know this because you understand the compound effect of interest and how inflation works,
what would happen if you approached savings like a mortgage (even if you don’t have one)?
A post I read on Mint.com by Matthew Amster-Burton inspired this question, and I ask it to get your attention about the present value of a (potential) future pain: not having saved enough. Yes, in this context I’m talking about the long-term goal of savings; yet, you know the essence behind this question can really be applied to anything.
This post isn’t intended to make you feel bad if you find yourself in the camp of having to play catch up in order to reach your 2013 savings goals. (Heck, I’m there with you!) But, I do have a challenge for you (and me): during the remaining six months of the year treat yourself just like you would a mortgage company.
Meaning: You’d do everything humanly (and legally) possible to make every mortgage payment, right? Otherwise, you’d risk losing your home. So…how might your net-worth be different not 20 years from now, but even just six months from now if you applied the same mortgage payment discipline and vigor to the practice of savings?
Do you get thrown off by generic savings buckets? Me, too! Therefore, segment your savings goals into various time buckets (1-3 years; 3-5 years; 5-10 years; 10+) and make sure – as we turn the corner that begins the 2013 wind down (freaky, right?) – you’re putting something into one or each of those buckets so that “the present value of a (potential) future pain” is simply the title of this post…not your reality!