The Time Value of Money, Revisited

Everyone reading this thinks they know what the time value of money is. A dollar today is worth more than a dollar in the future, blah blah blah.

But one thing I’ve noticed over the years is people don’t value the time value of money.

What do I mean by that? Let’s do an example. You have two investment choices:
a) invest $1000 and get $2000 in ten years. This produces a 7.2% annualized return.
b) invest $1000 and get either $2000 or $4000 in ten years. You have a 50% chance of each. The expected value is a return of 11.6%.

I think everyone would agree, based on the information above, they would choose option b. You are guaranteed at least as much as option a but with the chance to do twice as well.

However, there’s a catch. What if I told you that to have that 50% chance of $4000, you had to spend five minutes every day doing something menial, like say watching advertisements. If you didn’t comply, you only get the $2000.

Do you still prefer option b? I’m guessing some of you do. After all, it’s only five minutes a day to have a 50% chance of making $2000.

But now we have to do the math. Five minutes a day is about 30 hours a year, so 300 hours over the ten years. Would you really sell 300 hours of your labor for only $2000???

When you consider the time requirement to earn that extra return, is it really worth the effort? This is what I mean by the time value of money – how much time does it take to increase your returns and is that time a good investment of a limited resource?

Monitoring Costs

In finance, the term monitoring costs is often used to reference the financial cost an investor incurs to oversee an investment, such as hiring auditors to make sure the management isn’t stealing from shareholders.

However, I have a new and different version of monitoring costs. Monitoring costs are the amount of time you have to invest to keep track of an investment.

For example, the monitoring cost of a CD deposit is zero. The interest rate is fixed and there is no mark to market of the price so you can make your deposit and ignore it until it matures. A Treasury bond has a similarly low monitoring cost but since they are actively traded you may care about interim price swings before maturity so they may require a bit more time.

By contrast, an investment in a small business may require extensive monitoring cost. You will have to read the financial reports to know if it is meeting its targets. You may be asked to sit on the board and attend related board meetings. If you want to sell, you can not just put in an order online, you have to source a buyer.

There is a wide range in monitoring required in between these two extremes. However, investors rarely explicitly account for these costs when making an investment. My argument is that they should.

Low vs. High Monitoring Cost Asset Classes

One reason I only invest in publicly traded assets is because the monitoring cost is lower. A Treasury bond or S&P 500 index fund has close to a zero monitoring cost.

While private equity or venture capital may offer the prospect of higher returns, I don’t think that statement holds true after monitoring costs (not to mention taxes, liquidity, and other return drags).

Let’s say you are thinking of investing $100K in a private credit fund. You are probably hoping for 2% higher returns than a S&P index investment. Let’s also assume it requires 20 hrs/yr to monitor that fund between choosing which fund to select, reading the investor letters, figuring out whether the reported valuation is accurate, etc.

If you value your time at $100/hr, then your monitoring cost is $2,000/yr which is a 2% drag on your returns. That just happens to equal the entire excess return you were hoping for before monitoring costs!

(For those who want to argue it doesn’t take 20 hrs/yr, I’d argue back most people reading this value their time above $100/hr and we can find plenty of private investments that require well more than 20 hours.)

What other conclusions can we draw? People look at index funds all wrong. The traditional argument is one should own index funds because they are cheaper on an expense ratio basis vs. an actively managed fund so you end up with higher net returns after fees.

This is true, but they also have far lower monitoring costs than trading individual stocks. Thus, there is a strong case to own an index fund primarily for the low monitoring cost benefit.

What is a terrible asset to own from a monitoring cost perspective? Real estate! Lots of people like to own apartments because it can be tax efficient.

However, they ignore the huge monitoring cost. If you’re not handling maintenance yourself, you are paying someone to do it for you. You have to find new tenants, make sure rent is collected, deal with banks and accountants, etc. It is a huge time commitment for a small (if any) excess return.

How To Value Time

Of course, this whole concept has one big unsolved variable to apply it successfully, how should one value their time? Do you value it relative to your salary or, rather, to the marginal value of your time?

In other words, let’s say you make $100K/yr. At 2000 hrs/yr, that’s $50/hr. So is your time worth $50/hr? I would argue no.

Why? Well, if someone said, work 60 hours a week and we’ll pay you $150K, would you do it? Or would you expect more because each incremental hour of leisure time sacrificed is worth more to you?

You might say you wanted $180K, in which case you are now making $60/hr, but your marginal cost proved to be $80/hr (you make $80K more to work an extra 1000 hours). Thus, when calculating the cost of your time to monitor investments, it should be at least $80/hr.

I would even argue it should be more because each incremental hour is more and more valuable, so, for this person, I’d probably value their time at $100/hr.

The other way to value it would be to think about how much you are willing to pay to buy time. In other words, how much would someone making $50/hr pay someone else to do a one hour chore? Would they only pay the landscaper $20/hr or would they say it’s worth $80 to avoid having to commit their own time to it?

There is no right answer and everyone will have their own perspective, but my advice is everyone should understand the value of their time. I value mine far higher than the numbers in these examples which is a big part of why I no longer work (and why I don’t write as much as I used to!) but I also know my utility curve differs from most people.

Time Arbitrage

This brings us to the final concept I will cover today – time arbitrage!

Is it more efficient to:
a) spend time on high monitoring cost investments and pay someone to cut my lawn, babysit my kids, deliver my meals, etc.
b) spend time making your own meals and being with your kids and invest in simpler, lower return investments to free up time?

This is obviously a highly personal decision that depends on how you value leisure time vs. wealth. Most people don’t consciously think about these tradeoffs though. My argument is they should and should allocate their time to what they view as their highest value activity.

One thing I would note is it depends on the level of your invested assets. If you are investing $5,000 at a time, then it’s not very efficient to spend much time on it and I’d just use an index fund.

To use an extreme example, if you have $1 billion, then yes, it is worth spending time monitoring higher return investments as every incremental 1% return is $10 million!

Most people don’t have $1 billion though, so the decision is less clear. It is not difficult though to use this framework and figure out whether the time required to monitor more “exotic” investments is worth the extra financial return.

If it is, then you have to decide whether you value those extra dollars more than the alternative use of your time. If you have a hobby you’re really passionate about that consumes a lot of time, then you should definitely stick to index funds and Treasury bonds.

I should note one benefit of my investing career was I was restricted from making personal stock trades (other than index funds) to avoid potential conflicts of interest. This ended up being a hidden benefit.

Since my time was better utilized trying to make successful investments at work than at home, my arbitrage was to spend incremental time investing at work to increase my bonus to be able to buy more index fund shares rather than worrying about how to maximize the return on the personal assets I already had.

A New Efficient Frontier

Just as there is an efficient frontier to maximize return while minimizing risk, there is also an efficient frontier for maximizing return while minimizing time monitoring. Or if we’re really doing it right, the efficient frontier should be the mix of assets that maximizes return while minimizing risk and time spent.

It is surprising to me that the financial literature doesn’t account for the time investment required to make excess returns. It seems like such an obvious omission, at least to me.

If more people adopted this framework, I think you would see less retail interest in alternative assets. Private equity or VC still makes sense for pension funds or university endowments that are investing large enough dollars to justify the time investment to understand them.

But if your financial advisor is pitching you an opportunity to get into a private credit fund or tax advantaged housing or, God forbid, a reinsurance sidecar(!) you should really question whether it’s worth the time (and if you blindly invest without spending the time, well then don’t be surprised when the results aren’t what you expected!).

Unless you are investing large amounts of money or have proven investing skill, your efficient frontier is most likely one that minimizes investment complexity and sticks to simple instruments like index funds and government bonds.