What Do People Mean When They Say the Time Value of Money?
It Doesn’t Mean You Should Buy A Watch
Do you want a dollar today or a dollar tomorrow?
If someone offered you $30 now, or the same amount after 10 years, it would be a no-brainer to accept the money sooner rather than later.
But that’s not (completely) due to the human desire for instant gratification, nor our natural tendencies for greed.
It’s really because we appreciate the Time Value of Money(TVM): the concept that the money you have now, is worth more in the present than in the future.
How does this work?
Money doesn’t exactly decrease in amount as time goes on- a stack of $5 bills left untouched will look just the same several years from now.
However, the value of each $5 bill in the stack will decrease each year, as inflation — a constant increase in the prices of goods and services — occurs naturally in the economy.
Consequently, the purchasing power of each bill becomes less and less, until you find that your trusty $5 can no longer stretch for a Grande iced latte with coconut milk. Not even a Tall.
That’s why when older people talk about candy stores, while they might have noticed that the price of a candy bar went from $0.05 to $0.60 and think that’s ludicrous, it isn’t if the price of candy increased at 5% for 50 years.
Inflation Doesn’t Mean Forget Savings
Inflation cannot be an excuse to spend all your money at once, except in situations where countries experience hyperinflation (that’s for another conversation)
Saving money is still an important practice, just as long as it keeps up with inflation. And for the most part savings accounts are designed with that in mind; any money you keep there, is subject to interest rates which, most of the time, can keep up with inflation. Banks realize they have to give you something for saving your money with them and interest rates on accounts are the price they pay.
Otherwise, you could earn $100, put it in the bank for retirement, but when you go to retire, your $100 is actually $50 in purchasing power.
By even earning a small interest rate from banks, it allows your money to remain worth close to what it was worth the year that you earned it, which is essential for the modern day banking system.
Break It Down Further
So you can deposit any sum of money, and rest assured that upon withdrawal, the value will be about on par with the inflated prices of the future economy.
This can be looked at mathematically below, where FV stands for the Future Value, I stands fro the initial investment, R is the annual interest rate, and T is the number of years. This equation shows us a lot.
For instance, when inflation is higher than the interest rate you receive, then R would “in practice” be negative. So if you had inflation of 5%, and an interst rate of 1%, then you would in effect, lose 4% of your worth, and every $100 would be worth $96.
The equation also shows us that the interest rate matters less than T, because time is exponential. This is why people say that long-term investing & saving is crucial to financial success. Because then about it….
If your investment (I) of $2,500 makes 8% (the average return of the S&P 500 over the past 100 years) for 50 years.
After 10 years, your $2,500 would be worth $5,397. Nearly double.
Give it another 10 years? Now it’s worth $11,653.
30 more years? $117,254.
That is the power of compound interest.
So What?
Now we’ve seen, mathematically and conceptually, how the value of money changes with time. The moral of the story: don’t bank on the $100 under your bed to suffice for grocery money in the future.
Keep it in a savings account.
And once you have enough money saved in a Savings Account for an emergency shock, then start looking at long-term investments in the stock market. Because time & pateince are your greatest weapon when the value of your money is calculated exponentially.
