Perhaps you have come into a little extra cash flow and wondered, "Should I invest the extra money or use it to pay off something I owe?" It's a decision we are often forced to make without a great deal of consideration…but the results may have far reaching consequences! The three factors that ultimately determine the return on any investment are time, interest rate, and amount invested. If you could increase any single factor, which would it be and which would be second and third?
Would you rather invest $100 per month at 6 % interest for 30 years or $1,000 per month at 6 % interest for 10 years? If you chose $100 for 30 years you just made a $63,427 mistake.
Now, before you decide whether you should use your extra cash flow for the elimination of debt or wealth creation, let’s take a look at the following graph that compares Time, Interest Rate and Amount Invested.
Each of the three factors is represented by their separate colors and the Doubling Element, 1X...2X…4X etc., represents the doubling of one factor independent of the other two factors. For example, above 1X the interest rate is 1 %, the monthly amount invested is $100 and the time is 1 year. The results are equal above 1X because each factor is equal for each bar. Now let’s see what happens as we move to the second column labeled 2X. Above the 2X, the blue bar represents a doubling of time from 1-year to 2-years while the red bar represents a doubling of the interest rate from 1 % to 2 % and the white bar represents the doubling of the payment from $100 to $200. And remember; only one factor is doubled for each bar, the other two remain constant. As we move from left to right starting at 2X to 4X and so on, we notice a trend in the growth of each bar. Which factor would you choose to double if this were your extra cash? At 16X the blue bar represents 16 years, compounded at 1 percent and a $100 monthly payment. As you can see, TIME is by far the dominating factor and its growth is exponential.
Now that you understand the logic behind this powerful concept, let’s look at these factors realistically to see how they apply to everyday life, and how you can use this information to maximize your returns. The graph shows that you can make a significant impact on the factor of time by investing now, starting today versus later, but you only have so much time, and time is not a factor easily doubled. So, what about the interest rate, the least effective factor on our chart? You can have some control over your interest rate but as a general rule, the higher the interest rate the riskier the investment. So, we see that interest rates, or rate of return, are somewhat of a moving target, unless it is fixed, but no high-return investment is fixed. By today’s standards, a fixed 6-8% return would be considered quite an accomplishment.
In part two of The Three Factors of Investing, we discuss how the amount invested is the only factor that can be dramatically changed without taking on uncontrolled risks.
Please visit www.idealfsi.com for more information about managing debt and building wealth.
Author
Chad Sunyich |
