Don’t Waste Another Second: Discounting and Compounding
By Aaron Bush
Here’s a thought experiment.
The good news: I want to give you money. The bad news: You have to decide which option to take. Consider these three situations…
(A) I give you $100 today or $100 a year from today
(B) I give you $100 today or $110 a year from today
(C) I give you $100 today or $200 a year from today
What would you choose in each scenario?
This is what most people decide. In situation (A) choosing $100 today versus $100 a year from now seems like a no-brainer — it’s the same amount of money! Deciding to opt for the $110 or not in (B) is a bit trickier. And in (C) most people will take the $200 later instead of the $100 today. After all, the double is worth waiting for.
This all makes sense and folks are generally smart about it, but what I’ve realized is that most people haven’t quite internalized why. And the why has deeper implications than nearly everyone thinks.
Let’s start with the money
This much is simple: A dollar today is worth more than a dollar tomorrow. After all, if you receive a dollar today you can do something with it to make it worth more than a dollar by the time tomorrow rolls around. Or maybe you’ll just buy something worth $1 and attain that happiness a day earlier. When approached to take an equal dollar amount at different times, it only makes sense to opt for the earliest time available.
However, as in the case of receiving $100 today versus $200 a year later, people generally opt for the $200. Why? Because it’s unlikely that $100 will be worth $200 a year from now. Taking significantly more later is worth the time spent waiting.
But $100 now versus $110 later? Tricky, tricky. After all, that $100 could scratch a short-term itch, but what would that $100 be worth in a year? $110 perhaps? Therein lies the dilemma.
In finance, accountants and analysts love flipping the problem over on its head. On top of asking what could this $100 be worth later, they ask how much that $110 of the future is worth in today’s dollars. That simple mathematical act is called discounting.
To determine how much to discount by, you need to decide what your “hurdle rate” or discount rate is. In other words, what is your desired baseline rate of return? 10% is often a standard go to answer (that’s roughly the long-term average annual stock market gain), and we can briefly use that to show what I mean.
Here’s the simple formula:
Present value = future dollar amount * (1-discount rate)^# of years
Put to use:
$100 = $100 * (.9)⁰
$90 = $100 * (.9)¹
$81 = $100 * (.9)²
In other words, the further ahead in time we are set to receive the $100 (the rising exponent), the less it ends up being worth in terms of its present value. Keep that in mind the next time someone says “I’ll pay you later.”
That’s enough math. Let’s loop it back into what’s practical. How does this apply to every day life and personal finance?
Pull income forward and push expenses backward. Companies do this, and individuals can do it to some degree, too. After all, receiving money today is better than receiving the same amount tomorrow. And on the flip side, because today’s dollar is worth more than tomorrow’s, it’s best to push back parting with it as long as possible and put it to optimal work for as along as you can. For example, maybe work that extra shift this month instead of next month, and think about pushing back buying a new car until a little later.
Don’t delay investing. Seriously. Legendary investor Warren Buffett said his largest investment mistake was not starting earlier… and he started at age 11. Think about it. He’s worth $65 billion today, and the stock market returns 10% on average. Investing one more year (on average) would lead to another $6.5 billion. Not bad. Those spare dollars early on may have looked inconsequential, but the power of long-term compounding is almost too extraordinary to fathom. Don’t waste any more time.
Put more money to work, earlier. In a similar vein, time is your friend and the more money you put to work early on the more you’ll have in the end. Young adults often have the mentality that “This is the time to be living for me. Treat yo self!” If you want to cripple your eventual net worth and quality of life, be my guest. Or be patient and the reap the oversized rewards later. Your choice. I’m not insinuating that you can’t do anything fun or own anything nice now. You can and should, within reason. Some things are worth paying up for. I’m just saying be smart about it and be aware of the long-term effects of your current actions. Decisions become easier when you really think it all through.
Beyond the Money
Obviously, the concepts of discounting and compounding are of paramount importance when it comes to your personal finances. They’re nice mental tools to keep in the back of your head for when decision making times roll around. However, what I think people — inside and outside the money world — sometimes forget is that the same mental models that apply to money can apply to other realms of life as well. Discounting and compounding are perfect examples, and they’re almost hiding in plain sight.
The earlier you learn a new skill, the more advanced you’ll be in the end.
The earlier you begin a project, either the sooner you’ll finish or the better it will be by its due date.
The earlier you take exercising seriously, the more in shape you’ll be in the end (and sooner).
The earlier you decide to read that book or article, the earlier you can apply its teachings… and the greater the impact it has in the end.
The earlier you hustle in your career, the farther your career could go in the same amount of time as others.
And so on.
It’s a universal truth: Tomorrow builds on today. If you start today, tomorrow automatically begins on better footing. The falling dominoes are set into motion sooner. If put on repeat, the long-term benefits begin to show merit sooner than you’d think — you’ll always be a step ahead. In any realm where growth takes place, please don’t waste another second.
Think about it. What can you do right now that you shouldn’t push off anymore? Now do it. Let the compounding begin and let your discounting decisions bring you the best results possible.
Carpe diem — seize the day.