All investments, big or small, have three structural components: the amount of money invested, the expected rate of return, and the time or duration of the investment. Many investors, especially smaller, private ones, are familiar with the first two components, but don’t pay that much attention to the third one.
The Time Value of Money: When a future investor attends a business school and studies finance, one of the most important lessons that’s taught is the Time Value of Money. In short, money always has a certain value in relation to a time frame. A dollar that is uninvested today has missed whatever return was available for that day. This is the main reason that good investment advisors recommend keeping money into the markets instead of trying to time the market by buying the dips and selling the peaks. Studies have shown that over the long run the investor will miss the days that the markets make gains if he’s trying to time the market and his money is on the sidelines. It’s true that if an investment is liquidated before it goes down, the investor protects his gains, but he will waste opportunities if his money is not at work.
The Value of Indexing: How can the time value of money be determined? Indexing is one technique whereby an economist can determine the change in the value of money over time by analyzing changes in prices of various commodities and services. This can be helpful in a broad sense, but there are many mitigating circumstances that could come into play. The best indexes are most useful over shorter to intermediate periods of time. I had a college professor who was attempting to develop an index from the late 1960s back to the late 1770s, or revolutionary war times. His approach was to look at how the army fared back during the revolutionary war versus how it fared in more recent times, that included the Vietnam War. For certain things, such as food rations, uniforms, firearms, ammunition, and soldier’s compensation, this approach might work. But the army in revolutionary times did not have helicopters, tanks, rapid fire weapons, radios, parachutes, air-to-ground missiles, and radar, as it did in Vietnam. I don’t know how the professor’s project worked out, but the point here is that the shorter the time frame an index covers the more accurate the index.
The Inflation Effect: Inflation is and will always be a major concern for investors. A businessman who wants to build a factory to make electric motor vehicles, for example, could be making a multi-billion-dollar commitment to begin this venture. He needs to know how many cars will be sold and how much each car will make over the costs involved—not only for the first few years, but for the next ten or twenty years at least. The billion-dollar investment will have a price tag for the amount of money borrowed, and he needs to know how this will be paid off. And the businessman needs to know the answers to all of these questions before he starts. Many of these factors are calculable, but what happens if the currency used in the calculations is faced with inflation? Some inflation exists in our economy virtually at all times as the Federal Reserve strives to keep inflation to about 2% annually. But when times are uncertain and a high degree of inflation seems likely, what can the car maker do about his grand investment. He could add inflation considerations into his calculations, but inflation has a strange nature in that it affects certain areas of the economy before it affects other ones. Inflation generally begins from a demand/pull standpoint whereby the demand for a product or service exceeds the supply resulting in a higher price for that product or service. But as inflation continues, the demand/pull effect can get replaced by a cost/push effect as inflation reaches other parts of the economy, like what happened in the late 1960s and 1970s. Inflation makes good material for a different blog, but it should be ever clear that a currency that is eroding owing to rapid inflation can definitely impact the time value of money.
The Impact of Time on Returns: We know that both fixed and equity investments have returns that include both price appreciation and dividends or interest. The yield portion (dividends and/or interest) is measured and retrieved in terms of time—semiannual interest payments or quarterly dividends for example. In some fixed investments, the time component actually determines the rate, as the amount of return is fixed and is payable a certain date. But the price appreciation portion of returns is also impacted by a time element. Buying a stock for $25 per share and selling it one year later for $30 per share is an annualized return of 20%. But if the same stock were sold for the same price after only six months, the annualized return would be 40%. The increased rate of return is a direct result of the shorter holding period, but in the broader picture it would wind up being the same return if the money sat on the sidelines for another six months before being invested again.
Interest Rate Effect: Anyone who has ever had a credit card, a mortgage, a car loan, or borrowed any money from a bank should understand interest rates. But the same interest rate effect takes place with other money matters that do not involve borrowing. Returns from equity investments can be evaluated by comparison to actual interest rates that could provide an alternative. The financial news each day refers to the rates for treasury bonds in that they provide (arguably) the safest alternative investment not only to any other fixed investments, but also to most equity investments. The comparison with other investments then boils down to the risk, as the cost of capital becomes easier to evaluate. As I’ve mentioned in other blogs, dividends have a great relation to the time value of money, as many dividends are determinable over certain periods of time, and in a lot of cases the holding periods can be shortened to the investor’s advantage.
Conclusions: All investing has three structural dimensions: principal, rate, and time. Investors can choose the amount of principal and pick their way through rates. But they do not always consider the third dimension and that is time or duration.