The time value of money is one of the most important concepts to grasp in investing. Happily, it’s a pretty instinctive one.1

The time value of money reflects how you’d rather get a certain sum of money today than exactly the same amount of money in the future.

Money in the hand now is worth more than exactly the same amount received in a year’s time.

This explains why locking your money away for a longer time (usually) earns you a better return.

The longer you lock your money out of reach, the less it is worth right now.

You need to expect a higher return on your investment to compensate you.

Show me the money!

Which of the following would you prefer?

• £1,000 now

• The promise of £1,000 in five year’s time

Of course you – and all rational investors – would prefer to receive £1,000 today.

Five years is a long time to wait. Even if you didn’t want to spend £1,000 right now, you could put the money received today into a deposit account earning interest for five years. If you got 4% interest2 on £1,000, then after five years your money would have grown to £1,217.

Why choose to have £1,000 in five years when you could have £1,217 by taking £1,000 now and investing it?

It’s a no-brainer.

Looking further out

Let’s extend the idea to imagine you’re deciding between:

• £1,000 in five years

• £1,000 in ten years

Anyone sensible would prefer to have £1,000 in five year’s time, rather than to wait ten years for exactly the same amount.

Time value thus describes a continuum. A sum of money received now is worth more than exactly the same amount in the future, which in turn is worth more than the same sum at a date beyond that.

Finally, let’s say you can get 4% interest on cash today, as in my example above. (We’ll ignore taxes and the like for simplicity.)

Which would you choose between these two options:

• £1,000 today

• £1,040 in a year’s time

If you could expect the £1,000 received today to earn 4% interest over a year, then the value of these two choices is the same.

How do we calculate the time value of money?

All other things being equal, the time value of money represents the interest one might earn on a payment received today, if it was held earning interest until a future date.

The fixed income from safe government bonds is normally used to calculate the present value of a future payment.

The income from government bonds is assumed to be a risk-free rate of return.

But what if that future payment is not guaranteed?

What if your I.O.U. note comes instead from your cousin Bob? Or from a volatile stock market-linked investment such as a share or an index fund?

Without the certain guarantee that you’ll eventually be paid the full amount, the future value of the same sum of money is even lower because uncertainty as well as time value makes it less attractive.

A discount rate can be used to estimate the present value of that future uncertain payment. This discount rate reflects both time value and risk.

As an everyday investor – particularly a passive investor – you may never bother using a discount rate to work anything out. Leave that to analysts.

Just realise that there is (or should be!) mathematics and reasoning behind our gut instincts about saving money.

Time value of money and your investments

Time value can be used in financial calculations to work out things like the present value of a growing annuity.

Such calculations are often built into calculators and spreadsheets. You can find some worked examples on the time value of money Wikipedia page.

But as I say, we’re only looking to understand the gist of the theory here.

The rule-of-thumb is that money put away for longer periods of time will need to offer a higher rate of return to compensate for it not being available to invest in other (potentially superior) assets during that time.

Uncertainty about the future also plays a part, as I mentioned.

Uncertainty is in some respects another word for risk. Remember that that there are many different types of risk when it comes to investing. Usually you’re just swapping one risk for another to best suit your circumstances.

In a savings account you’d be worried about inflation, for example.

Would you be wise to lock away your money for five years at 5% if inflation was 4% and rising?

Probably not.

With a fixed duration security such as a government bond, the nearer today’s date is to the date the government will fulfill its promise to buy the bond back from you, the likelier it is to be priced close to its redemption value.3

Look several years out though, and time value combined with uncertainty about factors such as inflation and government debt will more influence the price of that bond, moving it above and below its redemption value.

Key takeaways

The maths can get complicated, but the takeaway is clear. For all assets, time, uncertainty, and expectations combine to influence risk and return.

Time value of money is often neglected by private investors. But you do need to consider it when deciding whether a particular asset and/or the income it produces makes it a good investment.

This article on the time value of money is one of an occasional series on investing for beginners. Please do subscribe to get our articles emailed to you to learn more! And why not tell a friend to help them get started?

1. Note: It’s not to be confused with option time value. Nothing is simple with options! [↩]
2. I’ve just picked 4% as an example, to keep the maths meaningful. I know you can’t get 4% on cash currently. That’s not the point here. [↩]
3. The redemption value is the money you’re promised to be paid by the government when the bond’s lifetime is up. [↩]

What caught my eye this week.

A key trait as an investor is the ability to change your mind. That’s because we’re all wrong about stuff, all the time.

I don’t mean you that should flip stocks on a whim, or pick-and-mix this season’s asset allocation like you’re choosing a t-shirt for the beach.

Staying power is crucial, whether you’re a passive investor or you’re chasing market-beating returns for your sins.

But being able to change your mind is equally vital.

It’s estimated the best stock-pickers only get about 60% of their calls right.

The high-speed traders at Renaissance Capital reportedly generated billions by being right just 51% of the time.

If you want to make money when you’re so often wrong, it helps to admit it.

What would change your mind?

I love the Financial Times and I’m a very satisfied subscriber.

But boy have its pundits been wrong about Tesla.

For the better part of a decade I’ve read snarky comments in the FT about Tesla’s valuation, its shareholders, and the showmanship of Elon Musk.

Some concerns were valid, sure. But when during Tesla’s ascent should the skeptics have upgraded their thesis?

When Tesla shipped its first electric car?

Maybe when it rolled out the mass-market Model 3?

Or when Tesla turned profitable?

Or when it achieved its goal in 2020 of producing 500,000 vehicles in a year?

Now Tesla is valued at $1 trillion. The FT covered that. But its scribes couldn’t resist joking that the new 100,000 car deal with Hertz that drove this latest price spurt was mostly about burnishing the latter’s meme credentials.

In a more balanced piece yesterday the paper conceded:

Out of the Musk limelight, Tesla has been building an increasingly solid business.

Good for them. Griping all the way to $1 trillion wasn’t a good look. But better late than never to think again.

Sinking feeling

At least journalists don’t have their money on the line.

Hedge funds have lost billions shorting Tesla stock.

It was always a dumb short – as I mentioned in my post on my own Tesla woes – because Elon Musk had super-rich Silicon Valley friends who’d said they’d back the company with capital in a heartbeat.

Some of those shorting Tesla even called it a fraud after it made what’s become the best-selling premium sedan in the world. At that point they should have admitted they didn’t understand what was going on, and stood aside.

There’s no shame in it – and it’s easier on your wallet.

Tesla has a mammoth task ahead, and even as a shareholder I agree its valuation looks stretched. But you have to appreciate everything it’s doing right before you can bet against what could go wrong.

If you don’t understand something then you shouldn’t be shorting it.

Big mistakes

All this is more easily written than done.

As a naughty active investor with thousands of companies to misunderstand, I get six things wrong before breakfast.

Yet passive investors can go off the rails, too.

Some concede they know no better than the market and so pursue an indexing approach – a noble strategy – but then call bonds a bubble waiting to burst for a decade, or shun US stocks for years, seeing them as overvalued.

One huge danger with these big macro calls is that the sunk cost of being so wrong so far makes you desperate to eventually be right to fix things. Such mind games can take your portfolio far away from consensus.

Conversely, another risk is actually admitting you got it wrong, changing position, but doing it so late in a bout of market mania that you end up taking all of the pain of a correction with little of the previous gains.

Avoiding using your feet for target practice like this is another subtle benefit of an automated approach like our Slow & Steady Passive Portfolio.

Wrong way, right turn

None of this is to say that the market doesn’t get it wrong sometimes too.

Over on his Compound Advisors blog this week, Charlie Bilello posted a great selection of times when the wisdom of the crowd proved more witless.

Of course those examples are so striking because we know how they ended.

Those investing on the way up – or down – had no idea where the story would finish. All they saw was a one-way ticket, right until the road ran out.

So for my part I strive to be ready to change my mind on a dime. ‘Strong convictions, weakly held’ is the way the cool kids put it.

If that’s difficult with investing, then take heart that at least it’s easier than with politics or as it transpires epidemiology…

Have a great weekend, and don’t forget that business with the clocks!

[continue reading…]

Part one of this two-part series explored why the future expected returns of the 60/40 portfolio are unlikely to match the last ten years.

In a nutshell, negative real bond yields plus richly valued US equity markets imply weak capital growth ahead.

Past experience shows expected returns predictions are more reliable than some chancer with crystal balls telling you that a dark, handsome stranger lies in your future. But not by as much as you’d think.

Still, a deluge of fiscal stimulus and near-zero interest rates has created a sticky financial quagmire. As a result, returns could be muted for a while.

In the face of all this, you can better position your 60/40 portfolio. But there are no magic bullets.

The alternatives come with consequences.

I’ll take you through the non-magic bullets you can fire in a moment.

First though, let’s talk about what not to do.

Don’t buy it

Improving expected returns typically means taking more risk. That’s the trade-off ignored by most of the 60/40 portfolio articles dominating Google.

Here’s a selection of their suggestions for your portfolio:

• Uranium
• Big tobacco
• Russian equities
• Private equity
• Hedge funds
• Timber
• Collectibles
• Music royalties
• Currency trading
• Junk bonds
• Chinese government bonds
• Infrastructure

The correlation between these ideas? They offer hope and are difficult to falsify. So let’s be clear. This is rampantly speculative stuff from the Donald Trump School of Medicine.

These articles are mostly generated by active managers and / or journalists. Their stock in trade is the turnover of ideas, not their quality.

60/40 portfolio: guiding principles

Recall that the 60/40 portfolio’s asset allocation aims to:

• Control risk and cost.
• Be simple to understand and operate.
• Work for investors with little interest in the market’s machinations.

None of those principles apply to the schemes I listed above. Mostly they’re complexity masquerading as strategy:

• Each ‘idea’ increases your exposure to risk and cost.
• They typically involve chancing your arm in opaque markets, which shortens your odds of being the sucker at the table.
• Little to no evidence is given to explain why these options are a good choice.

Sure, a couple of those suggestions may outperform a 60/40 portfolio in the next ten years.

But which ones?

In contrast, the following articles deploy evidence and data to expose how directionless some of those ideas are:

• The track record of hedge funds.
• Same again for private equity.
• Why narrow investment bets are a crapshoot.
• How recurring ideas like infrastructure, timber, and clean energy under-performed the broader market in the past decade.

As for Russian equities – they have been abysmal since at least 2007.

Moreover, autocratic leaders like Vlad Putin and Xi Jinping derive credibility from painting the West as an adversary.

Good luck landing outsized future cashflows as a foreign owner of Russian or Chinese securities.

Ditch bonds

The other ‘big idea’ you hear a lot these days is to drop bonds.

That’s because owning a large holding of government bonds right now is like riding a bicycle with a slow puncture.

But getting rid of them – or even switching up to a 80/20 portfolio? That ignores why government bonds are a mainstay of the 60/40 portfolio.

Holding bonds was never about earning big returns. The point of bonds is to lower the risk of you selling out when stocks crash.

Bailing can permanently damage your returns.

Yet this danger of cracking under pressure is not well understood, especially given how a bull market buries memories.

Panic is an insidious threat because we underestimate it.

Markets can be more brutal than most of us have experienced.

That’s why bonds are still a good investment, even today.

Some commentators state bonds can no longer protect your portfolio, but that’s not true.

These pieces show you why bonds retain some protective power, even at negative rates:

• How bond prices work.
• What bond convexity is and why it matters.

Alright, that’s enough about what not to do. Now for some practical suggestions for 60/40 portfolio investors.

Can you take more risk in your 60/40 portfolio?

The risk of investing in volatile asset classes means the answer to our malaise isn’t: “throw your bonds overboard.”

However, can you live with fewer bonds and more equities?

Can you handle a 70/30 portfolio, for example?

The answer will be very personal.

I’ve previously compiled the best advice I’ve found on risk tolerance to help you explore this issue.

One option is to try an industry-standard, online risk tolerance questionnaire. The idea is to discover the riskiest allocation you can comfortably deal with.

The big debate is whether such questionnaires work. The finance industry has used them for ages. But clearly they’re an imperfect measure.

So only increase your equity allocation cautiously and thoughtfully.

More risk, more reward?

Beyond incrementally revisiting your asset allocation, I wouldn’t recommend making changes on the risky, growth side of your portfolio.

That’s because the other options increase your exposure to investment risk and/or the risk of being ripped off.

For instance, long ago I invested in risk factors. The promise was outperformance in exchange for more risk.

Of course, I knew there was a chance my factor bets would disappoint.

Guess what?

I got the risk but not the reward.

Oh, and let’s shoot another white elephant in the room while we’re here.

The SPIVA study shows that active management is no solution either.

Remember, all the active money in the market – added together with all the passive index funds – is what makes up the market.

That means active management is a zero sum game because when one active fund wins another loses. Or more accurately: when one actively invested dollar or pound beats the market, another must do worse.

Active funds in aggregate can only deliver the market return – minus their higher fees.

The bond trade-off

Is there more you can do with your defensive asset allocation?

Perhaps.

Today’s government bond environment feels like a Tarantino-style Mexican standoff:

• Long bonds are your most potent protector against a deflationary recession.
• But they could inflict equity-scale losses if inflation runs wild.

• Index-linked bonds are your best defence against galloping inflation.
• However they won’t do much in a recession. And their yields are more negative than conventional bonds.

• Short bonds are as much use as a concrete zeppelin in a recession.
• But they’ll do okay-ish if the issue is inflation.

• Cash should be part of your mix, but it isn’t a panacea.

Which way do you turn?

Many fear the return of 1970’s stagflation will financially embarrass us like a kipper tie of woe. Meanwhile, the next recession is a ‘when’ not an ‘if’.

We need a portfolio for all weathers.

An intermediate gilt ETF holds short and long UK government bonds. It’s a muddy compromise that offers decent downside protection in a recession.

And owning some inflation-resistant, index-linked government bonds is de rigueur – even though they are expensive.

I discussed some linker options in this post. (Another global index-linked bond ETF (hedged to GBP) has come onto the market since.)

Fiddling around the edges

Higher-yielding bonds like corporate bonds and emerging bonds are not an alternative to high-quality government bonds in a 60/40 portfolio.

Emerging market bonds behave more like equity. You don’t need them. 

Investment-grade corporate bonds offer a little more yield in exchange for less protection than high-quality government bonds.

You’ll probably see owning US Treasury bonds mentioned, too. It’s a decent idea that could offer a smidge of extra return. But it only works under specific conditions. And the risks need to be understood.

You’ll have noticed by now that every ‘if’ comes with a ‘but’.

I prefer to keep things simple:

• Equities for growth.
• Index-linked bonds for inflation protection.
• Cash for short-term needs.
• An intermediate bond fund to cushion stock market falls.

However, I’ve been tipped off about a bond allocation that might work more effectively in the current conditions.

It’s an advanced strategy that requires a good understanding of bonds.

Long bond duration risk management

One logical response to a low yield world is to make like American politics and move to the extremes.

That means replacing intermediate and short bonds with long bonds plus cash.

This barbell approach hopes to capitalise on:

• The slightly higher yields of long bonds.
• Their better track record in recessions, relative to other bonds.
• The low duration risk of cash. This offsets the vulnerability of long bonds to rising market interest rates.

Here’s an example:

Desperate Daniella holds 100% of her bond allocation in an intermediate gilts fund with a duration1 of 10.

She replaces that fund with:

• 50% Cash (duration 0)
• 50% Long gilt fund (duration 20)

Daniella’s reallocation still leaves her with a weighted duration risk of 10:

• Duration 0 x 50% = 0
• Duration 20 x 50% = 10

The long bond duration risk is dampened by the cash.

This is not a free lunch. It gives you greater exposure to the longer end of the yield curve. That could be hard to live with should that part of the curve steepen in response to, say, spiraling inflation.

The idea comes from Monevator reader and hedge fund quant, ZXSpectrum48k. I’ll refer you to some of his comments on the topic:

• First comment
• Second comment
• Third comment
• Fourth comment

What about gold in the 60/40 portfolio?

From a strategic perspective, the best thing going for gold is its zero correlation with equity and bonds.

Gold randomly does its thing like Michael Gove in a nightclub – spasming erratically regardless of the drumbeat moving other assets.

Gold did amazingly well in the stagflationary 1970s. Back then equities and bonds got hammered. However, one-off historical factors were in play. The US Government had stopped fixing the gold price and legalised private ownership.

The yellow stuff smashed it during the Global Financial Crisis, too. But gold cushioned portfolios less successfully than gilts in the coronavirus crash.

And gold lost 80% between 1980 and 2000.

So no, gold isn’t a no-brainer. You still have to use your nugget. (Alright, that was just gratuitous – Ed).

Some model portfolio allocations like the Permanent Portfolio and the Golden Butterfly include a generous dollop of gold. How clever that looks depends mightily on the timeframe you pick.

Meanwhile, gold’s long-term return hovers right around zero. It’s crock-luck as to whether gold will work for you. The hope is it comes good when everything else fails.

For me, this boils down to a 5-10% allocation in a multi-layered defence.

Where does that leave the 60/40 portfolio?

We live in interesting times. Diversification remains the right approach.

The all-weather portfolio below is positioned for uncertainty, without sacrificing the principles that first made the 60/40 such a godsend.

• 60% Global equities (growth)
• 10% High-quality intermediate government bonds (recession resistant)
• 10% High-quality index-linked short government bonds (inflation hedge)
• 10% Cash (liquidity and optionality)
• 10% Gold (extra diversification)

This asset allocation maintains the 60/40 portfolio’s balance of growth and risk. Granted, it adds complication. But every asset has a clear strategic role.

That makes more sense than knee-jerking into private equity and uranium.

Remember the 60/40 portfolio was never a get-rich-quick scheme. It gained traction because it was good enough. 

For more:

• How to protect your portfolio in a crisis.
• More on defensive asset allocation.
• An easy way to move to a 70-30 portfolio.
• Why you should use short-dated global index linked bonds hedged to the pound. Part one and part two.

High-quality government bonds means gilts or a developed market government bond fund hedged to the pound.

Taking control with a 60/40 portfolio

The more effective countermeasures you can take are technically simple but emotionally difficult.

You can’t control future asset returns. But you can control these mission-critical factors:

• Contribute more money to offset lower growth expectations.
• Increase your time horizon to benefit from compounding.
• Lower your financial target to make it easier to hit. That ultimately means living on less, if we’re talking retirement.

To see what a difference this makes, run your numbers in a calculator like Dinky Town’s Retirement Income Calculator.

Adjust contributions, income target, and time horizon to suit your circumstances. 

See how things look under a range of expected return scenarios. Try plugging in optimistic, pessimistic, and middling predictions.

For example, these expected return forecasts come from Vanguard:

• Optimistic: 4% (75th percentile)
• Mid-ground: 2.6% (Median outcome)
• Pessimistic: 1.2% (25th percentile)

Those are 10-year annualised expected returns for three alternative universes.

To turn those into real returns, I’ve subtracted an average annual inflation guesstimate of 2% from Vanguard’s nominal figures.2

Put the expected returns into the calculator’s rate of return field via the Investment returns, taxes, and inflation dropdown.

Periods of lower (higher) returns tend to be followed by higher (lower) returns. Accordingly, you can hope for improved growth beyond the next ten years. The Dinky Town calculator lets you play with that, too.

The three most powerful changes you can make are putting more money in, waiting a little longer, and lowering your income bar. 

They also save you from meddling with your 60/40 portfolio if that suits your risk tolerance. 

Not-so-great expectations

Multiple crises over the past 15 years have trapped us in an escape room with no easy way out.

I wish there was a clear answer to this puzzle but there isn’t.

Taking action now means short-term pain for long-term gain.

On the other hand, what if the next decade exceeds expectations?

Hallelujah! We’ll be better off than we thought – living on more or retiring earlier.

In conclusion: fingers crossed.

Take it steady,

The Accumulator

1. Duration is a measure of sensitivity to interest rate changes. [↩]
2. Real returns subtract inflation from your investment results. They’re therefore a more accurate portrayal of your capital growth in relation to purchasing power. [↩]