How Does Time Value Of Money Affect Your Investment Results?
- Time value of money dictates that the timing of your investment return is just as important as the amount of the return.
- Dividends or other income can be reinvested, making them more powerful than capital appreciation in the long run.
- Income producing investments reduce your risk by bringing you closer to break even sooner compared to investments designed purely for long-term appreciation.
- Taxes favor investments focused on long-term appreciation compared to income.
One of the things that seems to confuse new investors is exactly how investment returns are generated. Broadly speaking, there are two ways two ways in which you receive a return on your investment, and it is important to understand the risks and tax consequences of both. First, returns can come to you in the form on income, paid monthly, annually, or really in any way that you agree to with the entity that you are investing in – called income. Second, changes in the underlying value of the asset you have purchased generate a return on your investment – called appreciation.
Let’s look at this in terms of real estate. If you purchase a condo with the intent of renting it out, you will receive rental income in the form of monthly checks from your renter. Your actual profit is the rent minus your expenses which could include mortgage payments, realtor fees, taxes, insurance, travel, among other things. Your net profit is your income component of your investment return. In the last few years, though, with real estate prices escalating so much, many investors are looking at income as the secondary method of making money. Initial purchase prices are so high, the rent collected barely covers mortgage payments, so they are counting on price appreciation to turn a profit.
If over time the condo appreciates in value, you will be able to sell for more than you bought the property for, and you will realize a profit. Remember, profit from appreciation is not real until the property is sold. You can say your property has appreciated, but until you sell, you can never be completely sure by how much. An asset is only as valuable as someone else is willing to pay for it. No buyers, and it’s not worth as much as you may think.
Determining your real rate of return
Watch CNBC for a few minutes, and you will see the commentators discussing the price change of various stocks and stock indexes. There is very little discussion of the income aspect or dividend. Even with bonds, most of the discussion is relating to the price change of the bond itself.
Income, though, is critical to understanding your real rate of return. Why? Because when you earn your money is just as important is how much money you ear. Look at the chart below.
In both Investment 1 and Investment 2 $10,000 is invested. In both cases, at the end of 5 years, you will have $15,000 for $5,000 in total profit. So, the rate of return is the same right? But example 2 is a much better investment, because you have received some of the money in years 1 through 4, making that money more valuable. The real rate of return on Investment 1 is 8.45% and it is 10% for Investment 2.
The reason the timing of profit is as important as the amount of the profit is best explained is the concept of time value of money. Investment 2 is a better choice because you would be able to reinvest the funds received in years 1 through 4, pushing your return even higher. Money today is worth more than money tomorrow. Looking at the graphic again, if you were to reinvest the $1,000 per year in income at 6%, by the end of the 5th year, you would have $15,975 instead of just $15,000.
We all want assets that appreciate, but never discount the value if income and when you receive it.
How does the type of investment return relate to risk?
Money today is worth more than money tomorrow, so getting some of your money sooner rather than later potentially reduces your risk. The fact is, every dollar received as income is bringing you that much closer to breaking even with your original investment. If you invest $10,000 in something, and then receive $10,000 in income, you are less concerned about your original principal value declining.
In stock marketing investing, most companies who pay dividends do so regularly, or on a schedule that rarely changes. The income aspect of the stock can be considered fairly low risk. The stock price, on the other hand, will fluctuate daily based on the economy, the overall direction of the market, politics, as well as the companies own quarterly results. There are so many more risk factors that affect price changes compared to income.
What about taxes?
In most cases, income from investment returns, are taxed at a higher rate compared to those from appreciation. Yes, you need to pay taxes on the realized gain from the appreciation of an asset that you have sold. Income in the form of rent or bond interest or most stock dividend is taxed at your highest marginal rate, which could be as high as 37% in 2018. Realized capital gains on assets held more than one year and qualified dividend, though, are taxed at a maximum rate of 20%, but for most people it is 15%. From a purely tax perspective, gain from appreciation is more tax efficient.