When you deposit tuppence in a bank account
Soon you'll see
That it blooms into credit of a generous amount
- George Banks in 'Marry Poppins'
Yes, when in doubt turn to Mary Poppins for advice on the subject of money and career options. She also appears to be a chief architect of Republican health care reform, but that's a different article. Disney may have shown us a group of dour men who needed to learn how to have fun, but they were absolutely right.
If you invest your tuppence wisely, soon they will become so much more. The secret to understanding that is future value.
What Is Future Value?
Future value is the value today of money at a future point in time. For example take a $10 investment that would grow to $100 in five years. The future value of that $10 investment is $100.
It is the value today of money tomorrow.
How to Use Future Value
Future value is based on two related concepts: opportunity cost and the time value of money.
Time value of money is the idea that otherwise equal sums of money are more valuable when collected earlier because of the potential for earning and investment. For example, say a company offers you the choice to receive your paycheck on the 1st or the 30th of every month. The paychecks received on the 1st are more valuable because you can invest them for 30 additional days.
Opportunity cost is value you gain from having money in your possession. It can also be expressed as the value you lose by not having it.
In our example above, receiving your paycheck on the 30th has an opportunity cost because there is a time value to having your money 30 days earlier. Once that money is in your possession you can invest it. Collecting your paycheck on the 30th gives your employer an additional month to collect returns on that same cash while you do not.
Future value is how you calculate the time value of your money. Going back to our example, if you were to take that paycheck and place it in an investment for 30 days it would grow. Let's say you get paid $5,000 per month. If you invest it all, over 30 days it becomes $5,100. Therefore:
• Future value of your paycheck is $5,100.
• The opportunity cost of collecting it late is $100.
Comparing Future Value
The chief use of future value is in comparing potential investment opportunities. For any given amount of money your future value will differ based on how you ultimately invest it. As a savvy investor, your best approach is to calculate this and compare potential returns.
There are several formulas for calculating future value. Ultimately the right way of running the numbers depends on which investments you make. For example, an investment with compound interest uses the following formula:
Future Value (FV) = Original Investment X (1 + Interest Rate)^Years Invested
For investments like a bank account, an annuity or even a particularly stable mutual fund, future value is easy to calculate. You can run the numbers on any range of potential investments to decide which is best for you.
Future value gets more difficult when results become speculative. For investments such as stocks, commodities, real estate, startup businesses and others you must balance your calculation against uncertain rates of return (down to and including zero).
The basic formula above is still the essential future value calculation: FV = Original Investment X (1 + Rate of Return)^Years Invested. So if you wanted to test run the future value of investing $1,000 into a stock for three years, and that stock has held a steady annual rate of return at 3 percent, you would calculate:
FV = $1,000 X (1 + .03)^3 = $1,092
Your future value of that investment is $1,092. Your opportunity cost of not making it would be $92.
Notice, though, the assumption we had to make there? We had to decide that this stock would replicate its past performance reliably for the entire three years we kept our money in there. This is where future value (despite its formulae) gets speculative.
Retirement and Future Value
Overwhelmingly the most important issue related to future value for the average investor is retirement. This is not only because retirement is how and why most consumers will put their money in the stock market. It's also because the future retirement value of your current income is enormous, and because the entire concept of retirement depends on it.
As you invest your money, every penny put away toward retirement has the future value of decades worth of growth ahead of it. Understanding that on an intellectual and gut level is essential to building a healthy retirement portfolio. Otherwise it's easy to see this as just a few hundred dollars, a drop in the bucket compared to the enormity of retiring.
Future value is why even $100 a month at 22 can mean hundreds of thousands of dollars at 65.