Thursday, July 25, 2013

Time value of money, money value of time

"Well a rich man counts his time/like a poor man counts his money"

The money value of time comes up a lot in personal finance, such as in the thought "My time is worth $__/hour, so it's not worth it for me to spend hours mowing the lawn/cleaning the house/etc. I'll hire someone to do that." This is a potentially useful heuristic, but I think the obvious formulation of it is way wrong. Leaving aside the question of whether the wage used is adjusted for taxes, the fact is that most people are not in a position to get payed anything at all for the time they would be using to mow the lawn. If you have a salaried job and no side gigs, the marginal value of an hour of your time is $0.

So decisions about whether to spend time or money on a problem or need aren't really about which solution leaves you richer. Spending time always wins. The question is how much it's worth to you to not have to spend that time. One way to answer that question is to put a value on the time you would have to spend based on what you would actually do with it--if you'd be watching TV, probably the number will not be high, but if the cost is time spent with your kids or doing a hobby that you love, it might be quite high. Another way to approach the question is to convert the money back into time, i.e. figure the time value of your money.

I don't recall seeing much discussion of the time value of money in personal finance writing, but it seems to me like a very useful quantity when trying to make good financial decisions. Here's my formula:

(annual increase in net worth) / (workdays/year)

It's very simple, and the quantity it produces is the money value of a day of your life. For example, for someone who saves $12,000 per year (I include debt principal paid as part of savings) and works a regular full-time job with 10 holidays and 10 vacation days, the formula says:

$12,000 / 240 = $50 per day

So a $50 concert ticket costs that person a day of their life.

Note that this is a heuristic for evaluating marginal and discretionary spending. Housing, insurance, and any established spending habits are already built into the savings number. Those are obviously important, but they're not really areas where time and money valuation heuristics come into play. They're subject to baseline personal finance rule #1: Spend no more than you need to on the things you've chosen to spend money on*. As for how to arrive at a number for total annual savings, assuming you're not a Quicken or Mint or other tracking tool user, probably subtracting end-of-year statements makes sense. Or else get decent data for a few months and extrapolate. (I use Quicken, so I can tell you to the dollar.)

Note also that if your net worth is not increasing then you won't get a useful number from this formula. In that case you're either in a state of emergency or you don't expect to ever do better than scrape by**. The calculations for living in financial despair are quite different.

Armed with this quantity, you can go back and evaluate the amounts you want to spend on saving your leisure time. E.g. would you be spending 3 days' worth of money just to save one evening's worth of yard work?

*Baseline personal finance rule #2: Choose wisely what you spend money on, especially when it's recurring.

**Ok, yes, there's also the possibility that you're smoothing your consumption over time because you expect to make much more later. Which makes plenty of sense in some circumstances.