Friday, February 6, 2009

Should I Invest #3: ROI

Question #1 was about your timeframe. Question #2 is about your beliefs. Question #3 is about moving forward or backward. I think that the real difference between investing and consuming is ROI, or Return on Investment. As I said before, Investment = Sacrifice. When you invest, you give up access to something now (usually time, money, or access to some property) for an increase in future value - cash flow, appreciation, more knowledge, etc.

But by this definition, consumerism is sacrifice too. I buy a large-screen TV, I gave up money, and I get a return in value: better viewing, maybe more social interaction as friends come over, and something worth more money. So as a mathematician, it looks like this:
Investment = Sacrifice = Consumerism or
Investment = Consumerism

Is this true? No. One is sacrifice for more and the other for less. At the end of the day, did that sacrifice make you richer or poorer? To do this, of course, you'll have to know what you're actually spending. If you buy a TV for $800 on credit, you could end up spending $1,500 by the time you're done. Also a good thing to understand is the future value of money, which basically says that, all things being equal, you'd rather have $1,000 today over $1,000 in ten years, especially when considering inflation or interest earned.

An investor buys things that go up in value, and a consumer buys things that go down in value. If you borrow money to buy a TV, you're a consumer. If you borrow money at 5% and make 8% on it, you're an investor.

Things to take into account: interest rates, inflation, and taxes...

Some examples
If you take $100 and put it in the bank at 2% interest, in a year you have $102. You've increased your wealth, so that is an investment. Now say that inflation is at 3% - you really have more like $99, so you've lost money!

How about if you can make 8%? Say you're in the 28% tax bracket, now you're really slightly under 6%. If you have a mortgage, you could be paying that down instead, so if you are paying 6% on your mortgage, your money is equally well spent paying down the mortgage or investing it. Or is it? You get a tax break on your mortgage, so you're decreasing your tax savings by paying down the mortgage. Here inflation affects both equally, so we can ignore it.

Now, how about that TV? At 12% interest for putting it on credit now, plus inflation, we're looking at a negative 15% on half of the price. An easy way to think about that last thought - over the length of the loan, you owe on average, half the cost. So our $800 TV ties up an average of $400 over the length of the loan.

Another way to look at that TV - as the latest model comes out, it will be worth less. Now an $800 TV could be on sale for $600 in a year. Supposing you are willing to wait the year, you are looking at this: save $50 a month for a year and you buy it outright. Buy it now, and you'll pay $600 of the $800 + $96 interest, and you still will pay at least $300 by the time you're done with interest. Is it worth $300 to wait a year? Only you can decide, but if we up it by a factor of 3 for a TV worth $2,400 now, it gets a lot more appealing.

A good final point to remember is that money isn't the only way to keep track. Happiness, peace, friendship are all part of that equation too. This is why the final decisions have to be yours and yours alone.

No comments:

Post a Comment