How do you know if an investment is worthwhile? How can you be sure your investment decisions will amount to the ROI you need to retire? These are important questions every investor needs to ask themselves. And, in doing so, they need the means to find the answer. That means understanding how to calculate the future value of an investment.
Future value is one of the simplest, most basic calculations in the world of finance. Everyone from big businesses to retail investors benefits from understanding future value. Having the wherewithal to calculate it will answer pertinent investing questions—and provide guidance on how to act.
Here’s everything you need to know about future value—including how to calculate it and the variables that affect it.
The Formula for Future Value
The first thing to know about future value is that it’s mathematically derived. That means you can plug your investments into an equation as a way to extrapolate value. The formula for future value is PV(1+r)n, where:
- PV = present investment value
- r = rate of return
- n = the number of years invested
In simpler terms, this equation takes into account the value of your holdings and the two biggest factors affecting them: rate of return and time. This accounts for the compounding rate of investments. Here’s an example:
Marissa wants to calculate the future value of her Roth IRA in one year. Right now, it’s worth $42,000. Assuming she makes no more contributions in the next 12 months and the rate of return remains 8%, the equation is: 42,000(1+.08)1. The future value of Marissa’s Roth IRA in one year is $45,360.
Understanding the expected value of your investment a year from now or even 10 years from now gives you a baseline for expected performance. It’s a way to benchmark your investments, so you can measure over- or under-performance with time.
The Limitations of Future Value
It’s important to realize future value for what it is: a snapshot into the future. This metric doesn’t take into account any of the volatility that comes with the market and isn’t conducive to measuring performance. It’s an ideal metric used to establish a baseline for expectations.
If you look closely at the equation for future value, it’s missing some very important factors—factors that have tremendous impact on the actual value of an investment. Namely, it doesn’t account for inflation, fluctuations in interest rate or currency values. For these reasons, the further into the future you try to predict value, the less reliable the metric becomes.
Future value is a much more reliable metric for stable assets. Mutual fund investments, for example, tend to stack up to future value estimates further into the future. Trying to calculate the value of your small cap portfolio 10 years into the future is an exercise in futility, on the other hand.
Consider the Power of Compound Interest
Despite its flaws, future value calculations are a great way to sneak a peek at the power of compound interest. If you have a relatively stable investment and want to predict the compounding nature of your wealth, future value offers insight.
While PV(1+r)n is the gold standard for calculating future value, it’s not the only metric. The Rule of 72 is another great yardstick that can show you the power of a compounding investment. Simply divide 72 by the rate of return to get the total number of years it’ll take to double that investment. For example, if you’re getting an 8% ROI on an investment, it’ll take you nine years to double your money (72/8=9).
Future value and compound interest go hand-in-hand. As you consider periodic contributions to an investment fund, extrapolating future value can tell you if you’re on-track to meet your goals or outperform the market, among other insights. It all has to do with how prolific your investment is.
Use Future Value to Make Smarter Decisions
There are a few simple ways to maximize investment returns over time. You can check these strategies by calculating future value as part of investment modeling. That is to say, run the numbers before making any real investment decisions.
Rebalancing is the first way to capitalize. Take the future value of an investment, then check it annually. If it’s trending short of initial projections, compare it to other investments or sectors that are outperforming. If the investment is downright unprofitable, it’s a great capital gains mitigation opportunity (capital losses).
And if you’re investing in a managed fund, look at its past performance. Then, calculate future value and compare that to the broader market. It’s a great way to set expectations. For example, you might want to invest in a fund that’s consistently doubling the market—but this isn’t sustainable. Calculating future value will show you a trend line that’s unsustainable. Instead, you might choose to invest in a fund with a more achievable future target.
Looking ahead is one of the best ways to evaluate your decisions now. Whether it’s adjusting your portfolio or making a realistic investment, your ability to perceive future value sets better expectations for how to achieve it.
Keep Tabs on Your ROI and Portfolio Performance
The future value of an investment is anything but static. That means the value you calculate today could differ from the one you calculate a month from now, or a year from now. To get a clear and accurate picture of the trajectory of your investments, you need to monitor them in regular intervals.
Making smart investment decisions can go a long way in helping you build wealth. For the latest tips and trends, sign up for the Liberty Through Wealth e-letter below.
The simplest way to monitor your investments is to plug them into an investment calculator with regularity. Chart your investment’s rate of return and make sure it’s on-par with your expectations. If it is, continue with your strategy. If the trend line isn’t measuring up, it might be time to adjust your allocation—or, at the very least, investigate why your ROI is behind schedule.