Let's Do the Counting!

I received an email from a friend today asking about how to calculate how much money you should invest monthly if you want to have a certain amount in the future for your kids education fee. The calculation is actually derived from the basic concept of time value of money. Are you familiar with the concept? I've mentioned about the time value of money concept in the post: Financial Goal, but let me elaborate the concept with examples on this post.

I started with an example of one simple financial goal, i.e. you want buy a house with current value of Rp3,000,000,000 in the next 12 years. Assuming the inflation rate for property is 10% per year and the target return from investment is 15% per year.

The steps to calculate how much money you should invest monthly is as follows:

1. Determine the future value of the house in the next 12 years.
    With Excel, you can input the formula as follows:
    = FV(inflation rate, number of period, , current value)
    = FV(10%,12,,-3,000,000,000)
    Which resulted in: 9,415,285,130.
    The logic is as follows: if the house is valued 3 billion at the moment, with 10% of inflation rate, in the
    next 12 years, the value would be 9,415,285,130.

2. Determine the money you should invest regularly each month in order to have 9,4 billion in the next 12
    years, assuming you invest the money in a product which gives a return of 15% per year.
    In Excel, you can input the following formula:
    = PMT(target return/month, number of period in months, , - future value)
    = PMT(15%/12, 12x12, , -9,415,285,130)
    The result would be 23,620,763.

If you notice I put a blank in between two commas in the formula (", ,"), it is because the character is not suitable for the calculation we want to achieve. Hence we just leave it blank.

Now let us compare how much money we should save if we didn't have any investment and use savings instead. In order to achieve 9,4 billion in the next 12 years, we should save 65,383,925 per month, which is resulted from 9,4 billion divided by 144 months (equal to 12 years of savings). We could see that there is huge difference if we use investment instead of savings. Up to this stage, do you start considering whether your money is already put in the right place?

Another thing I would like to emphasize is the importance of the time to start investing. The sooner you start to invest, the lower amount you should regularly invest. Let's elaborate with the same example, however we shorten the period of financial goal into 5 years. Using the same formula as explained above, if we changed the number of period into 5 years, the future value of the house would be 4,831,530,000, which is lower than the future value of the house in 10 years. However, how about the money to be invested regularly? Using the second formula, we changed the number of period of months into 60 months (equal to 5 years) and the future value into 4,8 billions, the result would be 54,547,636, which is a lot higher than our previous calculation, 23,6 millions. Hence, we can conclude that the longer time difference between the financial goal and the day you start to invest, the smaller money you need to set aside. That's why it is very important to start your financial planning now.

Well, I hope my explanation is clear enough and not confusing you. You could use the same formula to calculate any other financial goal, if you already understand the logic. Please do ask if you have further questions or confusion regarding my explanation, I'll be happy to assist.

Cheers,
Indispensable Lady

PS: The assumption of inflation rate and target return should always be checked to the market to obtain reliable result.