Time: The number of years you have to allow investments to grow before you need to cash out. For most people, the best timeframe to consider would be the number of years till retirement.
Goal: The amount of money you want to have at the end of the time you will spend investing. For most people, the best goal would be the amount of money they need for retirement. Remember that if you retire at 70, given current advances in life expectancies, you might realistically need your retirement savings to last 20 years or more.
Return: The average annual rate of return on your retirement investment account(s). Your investment accounts should provide this historical information about how they have performed on average.
Time, Money, and Rates of Return
There are a few truisms about money that really are true. You should keep these truisms in mind when planning your finances.
- "Time is money." As time goes by, you get money from the interest on your savings, and the return on your investments. You also lose money to interest on loans, credit card balances, and other debt. The fact that you can gain or lose money for no other reason than that time has gone by is called "the time value of money."
- "It takes money to make money." If you don't have any money in savings or investments, the time value of money doesn't benefit you. In fact, if you have debt, you are losing money from the interest.
- "The higher your rate of return, the more money you'll make." OK, there's no such saying--there doesn't have to be. It's just so obvious. With a higher rate of return, you get more from your investment. People often don't realize how much money a higher rate of return can make them. Over 20 years, the difference between $100,000 invested at 5% and $100,000 invested at 5.5% isn't just twenty times 0.5% of $100,000, or $10,000. Because of compound interest (the interest on the interest over time), that half a percentage point alone makes a difference of $26,446.
Risk vs. Reward
Of course, you want the highest rate of return possible. But how do you get the highest return? There's always some risk that an investment will go bad. The only relatively guaranteed investments are CDs, which return hardly enough money to keep up with inflation. Generally speaking, the riskier the investment, the higher the return--but the bigger the chance you will lose money in the end. The one common rule of thumb is that the longer you have to invest, the riskier you can afford to be. Over time, the highs will probably more than make up for the lows. But if you have only a few years to invest, you will run a real risk of losing a large chunk of your investment.
In short, in order to maximize your money over time, you need a strong rate of return. But in getting a strong rate of return you need to weigh the risk of losing out.