There is always risk associated with investing. Sure, you can diversify your portfolio or hedge against risk by purchasing lowrisk securities such as bonds, money market funds, or certificates of deposit. You can also predict your portfolio’s growth based on the market’s average rate of return. However, the future value (FV) of an investment can indicate what an investment will be worth based on its rate of return. Here’s how it works.
What is Future Value?
Future value (FV) is the expected value of an asset based on an assumed rate of return on that asset, i.e. an interest rate, given that the amount of money or investment will be left untouched for the length of the investment. Future value is calculated based on the rate of return earned, such as simple or compounding interest.
Let’s say a $15,000 investment will be worth $150,000 in 30 years. then the FV of that $15,000 investment is $150,000. FV assumes there will be a constant rate of growth. It also believes that there will be a single upfront payment without any ensuing investments or withdrawals.
FV is an important financial concept because it helps investors determine the value of an investment during set number of years. Inflation, rate of return, or economic events, can change the value of money over time. Knowing an asset’s future value can help investors determine just how much each of those factors will affect their investment.
FV calculation can investors to predict profit generated by various investments. The growth from keeping an investment in cash can differ wildly from the growth of the same investment in stocks. The FV equation compares numerous options, but isn’t always incredibly accurate.
The FV calculation only works with a steady growth rate. While a savings account with a guaranteed interest rate can produce an accurate FV, more volatile stocks and securities will be harder to track. The FV calculation for volatile assets is a bit more complex.
Calculating Future ValueFuture value is determined differently, based on the type of interest earned. FV from simple interest uses one formula, while FV derived from compound interest uses another.
When determining future value using simple interest, you’d use the following formula:
Future value = initial investment * [1 + (interest rate * length in years of investment)]
Let’s say you put $5,000 in a savings account that pays 10% simple interest paid annually over 10 years. The FV of the $5,000 initial investment is $5,000 * [1 + (0.10 * 10)], or $5,500.
When determining future value using compound interest, which is interest calculated on the principal of the amount, including accumulated interest, use this formula:
Future value = initial investment * [(1 + Interest Rate) Number of Years]
Using the $5,000 example above, the first year of investment earns 10% * $5,000, or $500, in interest. The following year, however, the account total is $5,500 rather than $5,000. To calculate compounded interest, the 10% interest rate is applied to the full balance for secondyear interest earnings of 10% * $5,500, or $550.
As mentioned earlier, future value is calculated based on a steady growth rate. While an investor can count on an assumed rate of growth to an extent, it is by no means certain. That makes FV more of a prediction than a conclusion. Though, with some asset classes, future growth is more predictable than in others.
Potential DownsidesFuture value can be a valuable tool in determining an investment’s value at a set point in the future. However, it’s not foolproof.
For example, it doesn’t account for fluctuations in the market, such as with interest rates or inflation. both of which can have major impacts on the future value of said investments.
Why It MattersFuture value is an important concept in finance. Generally speaking, $1 today is worth more than $1 in 10 years unless it’s invested. That’s where the time value of money comes in.
This concept says that the value of any amount of money has the potential to be worth more in the future if it’s invested or earns a steady rate of return. That’s the value of time.
Future value helps determine the value of an asset in the future based on rate of return. This means that you can compare the value of your asset today (current value) versus the value of your asset in the future (future value). This helps an investor determine how to best allocate or invest assets.
Bottom LineDetermining the future value of an investment can be a powerful tool in the hands of investors, though it’s by no means a failsafe prediction. It’s also not without its downfalls.
For one, future value is based on a steady rate of return, which isn’t always realistic in today’s market. Second, it doesn’t take into account inflation or changes in interest rates, which can also be major factors in the future value of an asset.
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The post How the Future Value of an Investment is Calculated appeared first on SmartAsset Blog.
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