On the first day of my very first Investments course in college, our professor stated that he wished to take us all to the tattoo parlor down the street and have two phrases permanently inked on our arms. On one arm, he would write “Time Value of Money”; the other arm would read “Risk and Return”. Fortunately, that image alone was enough to burn those phrases into my brain and my arms remain tattoo-free. But his point was spot-on – these two concepts so permeate the study of finance and investments that we would encounter them over and over again, for the rest of our academic lives and careers to come. Best to get very familiar with them from the start.
At Vickery, we discuss the link between risk and return often, particularly during the construction of efficient, diversified portfolios for our clients. We probably don’t talk about the time value of money quite as often, perhaps because it’s a little harder to explain and less intuitive. A really good metaphor would be particularly useful! Matt Levine, a columnist for Bloomberg View, must have also sensed that need last year when he wrote:
“The Essence of Finance is Time-Travel”
Well I’d never thought about it quite that way, but he’s exactly right – lending (or investing) money is about moving current resources from the present to the future, and borrowing is about moving future resources back to the present. This is also a terrific illustration of the time value of money, as long as we also remember that, all else equal, resources are worth more today than in the future. Everyone would rather have a dollar today than in say, five years, because the future is filled with uncertainty and all kinds of risks. Most importantly, the present and the future are inexorably linked – and we call that link the discount rate.
Discount rates can be completely transparent and very low on short-term, risk-free securities like a one-month US Treasury bill. They may even approach zero if there is no risk of default or unexpected inflation. On the other hand, discount rates are usually much higher on a long-term, risky security such as a common stock, when the earnings and cash flows are uncertain, the risk of bankruptcy is real, and unexpected inflation could erode the value of dividends over time.
Discount rates are crucial to investors because they are synonymous with expected rates of return. The discount rate that makes a marginal investor indifferent between a certain dollar today, and an uncertain dollar in the future is also your expected return on that investment. This is the upside to high discount rates and an uncertain future – riskier securities must offer higher expected returns to entice investors to hold them.
While time-travel for investors remains in the realm of science fiction for now, your money can travel back and forth in time quite easily thanks to modern finance and free capital markets. We know that capital markets have rewarded patient, long-term investors with positive, inflation-beating returns. It just might help us as investors to stay disciplined if we imagine our money traveling through time, waiting for us in the future to meet our needs when we arrive.