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Chapter 15
Planning for the Future
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Learning Objectives
• Explain the concept of time value of money,
including factors that influence it and ways
to calculate it
• Explain the role of diversification in
managing an investment portfolio
• Describe how time value concepts affect
retirement planning
• Describe how time value concepts affect
estate planning
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Time Value of Money
• Time value of money
refers to the fact that
money received today is
worth more than money
received next year or the
year after
• We can put money to work
for us in various investments
• By putting your money to
work for you, you can begin
saving for any number of
goals
• Postpone certain purchases
now and save the money
instead
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Future Value versus Present Value
• Future value is the
projected value of a
sum of money at
some point in the
future
• Compounding is
earning interest on
the principal and the
interest earned in the
past
• Calculating future value is the
most important time value
concept when focusing on wealth
accumulation
• You can use this time value of
money tool to calculate how
much you can save by the time
you reach age 40 or 60
• Take a look at figure 15.1 to see
how compounding works
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Figure 15.1
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Future Value versus Present Value
• Present value is the
value of a sum of money
at the present time
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• Present value techniques are
the opposite of future value
• Instead of trying to take some
amount today (present value)
and seeing what it will grow to
in the future (future value),
you are taking some future
value and brining it back to the
present
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Figure 15.2
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Math for Personal Finance
• Assume that Jenise invested $1,000 in the
stock market and earned an average of
annual return of 12 percent.
• How much would she have after 50 years?
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Math for Personal Finance
• Solution: The formula solution is future
value = present value x (1 + interest rate)n,
where n = number of years. Jenise will have
$1,000(1.12)50 = $289,022.19
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Math for Personal Finance
• Shane’s uncle promised to give him $10,000
when he gradates college in one year.
• What equivalent amount could Shane receive
today assuming he could put the money in a
CD earning 4 percent?
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Math for Personal Finance
• Solution: This questions is asking for the
present value of $10,000. So,
$10,000/(1.04)1 = $9,615.38. In other words,
Shane could put $9,615.38 in a CD earning 4
percent and have $10,000 at the end of next
year.
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Compound Interest versus Simple
Interest
• Simple interest
earns interest only on
the original amount
or principal
• For example, if we had an initial
deposit of $2,000 earning 10%
interest, we would earn $200 in
interest the first year.
• We would earn only $200 the
second year also because we
would not earn interest on interest
• Compounding will always create
wealth faster for any given interest
rate
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Math for Personal Finance
• Jodi has invested $5,000 at 6 percent simple
interest rate.
• How much interest will Jodi earn in three
years?
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Math for Personal Finance
• Solution: Simple interest earn interest only
on the original amount invested. Therefore,
Jodi will earn $5,000 x .06 = $300 per year x
3 years = $900 in total interest
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The Concept of Annuity
• An annuity is any situation where you have
equal cash flows occurring at equal intervals
for a fixed period of time
• A car payment is an annuity
• We can also solve for the future value or
present value of an annuity
• Go back to figure 15.1 to see how saving an
annuity of $5,000 a year with 10% annual
return can generate a lot of money
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Using Financial Calculators
• Both present value and future value
calculations can be done on a financial
calculator
• Online versions of these calculators are
available (see figure 15.3)
• Follow the instructions and you can figure
the future value for an initial investment
given a certain interest rate and period of
time
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Figure 15.3
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Math for Personal Finance
• Using future value techniques for a lump
sum amount, calculate the value of a threeyear annuity of $1,000 invested at 5 percent.
Assume you invest the first $1000 today, the
second $1000 in one year, and the last
amount in two years.
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Math for Personal Finance
• Solution: The annuity formula in a financial
calculator will generate the same solution as this,
but understanding the process is important. In this
problem, you will simply calculate the value of
each $1000 amount and add them up. The value of
the annuity equals:
• $1000 x (1.05)3 = $1,157.62
+ $1,000 x (1.05)2 = $1,102.50
+ $1,000 x (1.05)1 = $1,1050.00
$3,310.12
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Rule of 72
• Rule of 72 allows
us to see how
long it would take
to double our
money for a
given interest rate
• We can use the rule of 72 in
figuring out future values
• For example, if you assume a 12%
return, you can divide 72 by 12 to
find out it would take roughly 6
years to double your money
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Rule of 72
• You can also use the rule of 72 to see what
kind of return someone is promising you
• If someone says they can double your money
in 8 years, you know that the person is
expecting an annual return of about 9%
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Check Your Financial IQ
• What does the time value of money mean?
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Check Your Financial IQ
• It means that money received today has a
different value than money received at some
other point in time
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Managing Your Investments
• A portfolio is your
investments
• Financial professionals can help
you manage your investments
• You will be in charge of what
strategy they follow
• You should always monitor your
investments
• You should keep your portfolio
diversified
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Diversification
• Diversification is
investing in a lot of
different types of
assets or asset classes
• Asset class is each of
these types of
investments
• Asset allocation is the
process of spreading
your investments
among asset classes
• Do not rely on any single type
of investment to achieve your
financial goals
• The kinds of investments can
have a lot of uncertainty
regarding their future
performance
• It is wise to diversify
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Diversification
• A diversified portfolio of assets will reduce
your risk
• Different asset classes perform better during
different economic periods
• Make sure you are properly diversified
• Don’t get caught with all your money in
stocks in a declining stock market
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Risk and Return Tradeoff
• When you make an investment, you are
making a tradeoff between risk and return
• If you want low risk, you must be willing to
accept lower returns
• Higher-risk investments give a reasonable
hope of higher returns to attract investors
• Just remember, no return is guaranteed
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Too Good to Be True?
• Whenever talking about investing money,
there are people out there trying to separate
you from your cash
• People might promise you a 20 percent
return without any risk
• Those types of promises are not reasonable,
so be very cautious
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Too Good to be True?
• There really are no get rich quick schemes
• Don’t let anyone rush you into a financial
commitment or trick you into thinking you
can beat the system
• It always pays to think about your
investment and do some investigating of
your own
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Check Your Financial IQ
• Why is diversification an important part of
managing your portfolios?
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Check Your Financial IQ
• Different asset classes perform differently at
different times and under different
circumstances. Having a variety of
investments in a variety of classes helps
protect the investor from excessive risk
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Retirement Planning and Time
Value Concepts
• There is no better time to start the process of
retirement planning than now
• You can accumulate wealth much more
easily if you have time to put your money to
work for you
• You can now see how much difference it
makes if you wait until you are 30 years old
to begin saving for retirement, rather than 20
years old
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Retirement Planning and Time
Value Concepts
• Establish some financial goals and then take
the steps to accomplish them
• Use a financial calculator to figure what
you’d need to save to reach your financial
goals
• Think about your long-term goals
• Financial security is not a bad thing and can
be achieved with some careful planning
followed by action
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Check Your Financial IQ
• Why is it better to begin planning for
retirement at age 20 than at age 30?
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Check Your Financial IQ
• If you start earlier in life, you can take
advantage of the power of time to achieve
greater results
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Estate Planning
• Estate planning is
the process of
determining how your
wealth will be
allocated on or before
your death
• Estate planning may be even
further into the future, but it is
something you should be aware
of
• In other words, what happens to
your assets when you die?
• Who do you want to leave them
to?
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Your Will
• A will is a legal request
for how your estate
(everything you have
accumulated during your
life) should be distributed
upon your death
• Beneficiaries are your
heirs
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• One of the most critical
tasks in estate planning is
the creation of a will
• In your will you can specify
who will receive your
estate—your beneficiaries
• A will ensures that your
wishes are followed in the
future and it can relieve a
burden from your loved
ones
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Your Will
• Intestate is when
you die without a
will
• If you die without a will, the court
will appoint an administrator who
distributes your estate according to
the laws of the state
• Dying intestate can result in
someone getting more than you
would have wanted and others
getting less
• Look at figure 15.4 for a sample
will
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Figure 15.4
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Estate Taxes
• Your estate may be subject to taxes before it
can be distributed to your heirs
• Review the current law on estate taxes
• Take the steps necessary to minimize the tax
liability for your heirs
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Trusts
• Trusts place assets
in the custody of a
third party known as
a trustee
• Estate planning involves
establishing a trust to transfer
assets in a manner that avoids
taxes
• All trust are legal mechanisms
that help reduce tax liability as
assets are transferred from one
person to another
• The trustee manages those assets
for the designated beneficiaries
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Check Your Financial IQ
• Why is it worthwhile to engage in estate
planning today?
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Check Your Financial IQ
• It can ensure that your wishes are followed
in the future and it can relieve a burden from
your loved ones
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Summary
• Understanding the time value of money
concept can help you see how important it is
to for the future
• Planning for the future is easier if you know
how much money you need to save and
invest
• Future value and present value calculations
can help you plan for these things
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Summary
• This financial math can help you evaluate
different investment options and manage
your portfolio
• Risk/return tradeoffs exists and you must
assume more risk to get a higher return
• Proper diversification can help you reduce
risk in your investment portfolio
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Summary
• Sound investing will allow you to
accumulate wealth for retirement and pass
some of this wealth to your heirs
• Estate planning and the creation of a will can
help you reduce the tax liability when you
pass wealth to subsequent generations
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Key Terms and Vocabulary
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Asset allocation
Asset class
Beneficiary
Compounding
Diversification
Estate planning
Future value
Intestate
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Portfolio
Present value
Rule of 72
Simple interest
Time value of money
Trust
Will
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Websites
• www.moneychimp.com
• www.aarp.org/
• Resources.lawinfo.com
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