FINANCE 101: Savings and the time value of money
I have decided to sprinkle in articles on personal finance from time to time. These will be categorised separately under the heading in my blog “Investments and Personal Finance” (in the “Other” category), and will use “FINANCE 101” in the title. These articles will mostly cover basic money management concepts, the ones that are most important but also often forgotten.
This article will help you understand how your savings can grow over time, which is important to understand because the earlier you start to save, the better off you will be in the future. Systematic savings is a matter of discipline and organisation. It needs to become a habit, after which it becomes enshrined in your lifestyle and can almost be forgotten. As you are thinking about your savings, it is important develop savings objectives and to make sure that you understand the time value of money, or compounding. I started saving as much as I could afford very early in my working career. Even though I could only initially save small amounts, I always tried to save something regularly for specific objectives. I knew then that even small amounts today would become much larger over time. This philosophy has indeed proven correct, and I can attest to it. You can experience this, too, if you are disciplined with your savings and start saving early.
Savings should be attached to an objective, whether it be for retirement, your children’s education, a down payment on a house, or for a nice holiday. Let me share with you how my savings objectives evolved, and maybe these will resonate with you.
My first objective to save money was targeted towards my retirement, which at the time, seemed a long ways off in the future. I knew even back then that state-provided income (social security, state pension, etc) would not be sufficient as a sole source of income. Also, I always thought that I might want to retire earlier than the mandatory 65 to 67.
I was living in the USA when I first started working in the early 1980s. When I got my first job, I knew enough then to realise that I should think ahead and start saving for retirement. I decided to set up an Individual Retirement Account (“IRA”), and invested $1,000 the first year I started working, smaller than the permitted maximum allowance at the time (of $2,000/annum) but all I could afford. From that point onwards, I tried to set aside as much as I could each year for retirement across a variety of available vehicles, including IRAs, company 401K’s, company savings plans and ultimately a UK pension plan after I moved to the UK. I viewed this savings bucket as sacred – the pot was not to be touched during the ensuing decades to ensure that a “pot of gold” would be there when I retired. I will discuss retirement savings in more detail in another article, since these savings are often nuanced by things like tax deferred accumulations and employer matching of your contributions.
Eventually alongside the retirement savings bucket, I set up a second savings-focused bucket when my first child was born, perhaps not surprisingly dedicated to my children’s higher education. I was living in the US then, and my children started their primary education in public schools (i.e. state schools), which was “free” (if you ignore the exorbitant property taxes paid to fund state schools broadly). However, my wife and I were concerned about helping our children fund university fees, which even back then, looked daunting. I vividly remember buying the first stock (Walt Disney) for my son just a year or so after he was born. From that point onward, my wife and I would put money away regularly each year to build savings so that we could help pay for our children’s university education, important in retrospect since we eventually had three children. As with the retirement savings, this second pot was considered untouchable until it was to be used to pay for their university fees.
The third bucket I set aside was what I will refer to as “rainy day” money, invested generally for the long-term and available for uses like a down payment on a house, purchasing a car, going on family holidays, etc. Unlike the first two buckets which were truly of long duration, the amount in this third bucket could go up and down, and the savings could be used for shorter-term objectives. This third broad objective can of course be further subdivided into smaller more-targeted objectives based on your own priorities and personal situation.
To summarise, you should think about your intermediate to long-term objectives and set aside money for each of these. You might want to segregate your savings buckets in different accounts, each focused on a different objective. The ones that come to mind which I covered are:
Retirement (perhaps different types of accounts, but most generally tax-deferred)
Children’s education/university fees
Down payment for a flat / house
The time value of money
Let me begin with the mantra that is a key driver of setting aside savings: a dollar, pound or Euro saved today should be worth considerably worth more in the future if it is invested well during this period. Savings is a conscience decision to defer consumption – you could instead choose to spend all your money now and live “in the moment”, worrying about the future later. Look – I recognise that setting aside savings might not always be as simple as this. Many people need every cent they earn just to get by and pay for essentials like housing, food, clothes, transportation, education, childcare, and other basic needs. However, even if you fall into this category, my advice would be to make sure you are very diligent as far as managing your nondiscretionary expenses to try to set aside money in a regular savings programme, no matter how small the amount may be. Importantly, the earlier you start the better.
To give you a sense of the strength of compounding over time, I have created two tables to illustrate the importance of starting a savings plan early and focusing on investing the money in a way that both fits your risk profile and offers attractive risk-adjusted returns. The first table below shows the amount you would accumulate based on various time frames (top) and at various returns (left side). It is based on a unit of 1 – so $1, €1 or £1 – being set aside and invested each year at the beginning of the period. For example, if you were to set aside $1,000 each year for 20 years and it grows on average by 5%/annum, you would have $34,719 at the end of 20 years.
The second table below illustrates the amount you would accumulate in excess of the amount you have invested over the years. For example, if you were to again invest $1,000 each year over 20 years and earn 5%/annum, you will have accumulated 1.736 times ($34,719) more than the amount you invested (i.e. $20,000) over the period.
As you might also surmise from these two tables, the annual amounts you earn on your savings over the period in question is extremely influential. This is because earnings are compounded over time, meaning that you earn interest on interest (or dividends on reinvested dividends). If you are wondering how realistic these returns are, the table below extracts data using historical returns on three principal asset classes – US equities, US Treasuries (short, intermediate and bills) and corporate bonds.
These asset classes are by no means exclusive since there are many other asset classes in which you can invest, but they nonetheless provide you with a look at historic total returns on several of the largest traditional asset classes. This data is from the 2022 Ibbotson/Harrington study Stocks, Bonds, Bills & Inflation (SBBI) sponsored annually by Morningstar, Duff & Phelps and the CFA Institute Research Foundation. As the data shows, returns in the 6%/annum to 8%/annum range are not unrealistic at all based on an asset mix skewed (as it should be) towards equities.
I recognise that every person has unique savings objectives and is able to save varying amounts, but hopefully this article shows you that – once you define your objectives – the earlier you start saving, the better off you will be in the future. Having said that, also keep in mind that it is never too late to establish a systematic savings programme.
 As an aside there is a plan in the USA known as Section 529 Plan that allows savings for educational expenses to accumulate on a tax-deferred basis. A similar but more flexible (in terms of ultimate use of proceeds) scheme in the UK involves Individual Savings Accounts, or ISAs.