The Dollar Box Part 2
Last week I posed a question for readers to think about over the weekend. In case you missed it, here it is again.
I’ve got a box. It’s about the same size as one you’d get when you buy a new pair of shoes. But every year on January 1st, this box prints a dollar. The dollar is legal tender. When I say it will print a dollar every year, I mean every year. It will never stop. A million years from now, it will still be printing a dollar on January 1st.
I’m going to give you the box.
Now you have to decide, what’s the minimum amount of money you would sell that box for?
Some went down the route of, “however many years I think I’ll live plus one dollar”. Other answers I got included “infinity dollars” and “I wouldn’t sell it.”
A few people argued with me that a dollar is worth more to some people than others.
If you’ve seen the film ‘Becoming Warren Buffett’, you’ll remember that the world’s second-richest person actually brings the exact change with him every morning to buy his McDonald’s breakfast. Clearly Buffett has a very different relationship with money than most people. Despite all his wealth, he is incredibly thoughtful about how he spends every dollar. The other extreme would be those people who have very little but spend lavishly on things they don’t need. Most people sit somewhere in between. However, because in this hypothetical scenario you’re being asked to exchange “the dollar box” for money, it doesn’t really matter what a dollar means to you. That’s a totally other Daily Insight that I should definitely consider writing in the future.
The Dollar Box problem gets to the heart of what finance is all about — that a dollar today is worth more than a dollar tomorrow. This is also known as the “time value” of money.
First of all, we have to consider inflation. A dollar today has more buying power than a dollar tomorrow because of inflation. Yes, occasionally there are examples of deflation, but over the long-term, money loses value. The average rate of inflation since 1913 has been just over 3%. That means that what you can buy for a dollar today, you’d need $1.03 to buy next year.
When we stretch this out over time, we start to see a problem. In 24 years, that dollar that it’s printing out only has the buying power of what 50 cents has today. In 55 years, it only has the buying power of 20 cents.
Then we have to consider the opportunity cost. A dollar today has earning capacity that a dollar tomorrow doesn’t. If we can sell that box for a lump sum today, we can invest that money in a way that could outpace inflation.
A decade ago there were a lot more options than there are today in terms of beating inflation. You could invest in a U.S. Treasury Bond and receive about 4% per annum. This was considered about as safe an investment as you could make. Then on the riskier side of things, you had stocks which historically returned 10% per annum. That difference is called the risk premium — it was what investors demanded in order to take on the extra risk of stocks. With the historically low interest rates that we have today, you’ll be lucky to get 1% on treasury bonds.
This is what money managers are constantly trying to figure out: how to match their clients with investments that match their tolerance for risk with a return on investment that will make them happy. Anyone approaching retirement will be faced with a similar problem — do I invest in an annuity with a guaranteed amount every year or do I invest in riskier dividend-paying stocks?
Without really thinking about it, we’re always making decisions about what to do with our money. It’s always important to consider the opportunity cost of spending that money.
We’ll delve deeper into these ideas in coming Daily Insights.