The time value of money is the most important concept in investing. It is the idea that money now is worth more than that same amount of money later. Why is this?
Remember opportunity cost from your intro economics class? If not, read this article for a refresher.
Imagine you have $100 today, and you can either hold it or invest it. If you chose to hold it, your opportunity cost is what you would have earned by investing it. By holding it, you are not earning interest on the money. According to the time value of money, that same $100 today is then worth less in the future since you could have used the chance to invest it and make money in the meantime.
Potential for Return
In order for the time value of money to make sense,it’s important to understand the idea of returns. Return on Investment (ROI) is the amount of money that someone makes on their invested money. It is generally expressed as a percentage. Let’s take a look at an example:
James purchases shares of a mutual fund for $1,000. A year later, his shares have grown to $1,120 in value. His investment has returned $120. His return on investment is 12 percent, which is found by dividing the return over the initial investment ($120 / $1,000).
James made this investment in the first place since the expected return was greater than or equal to his required rate of return. A person’s required rate of return is the amount of return necessary for someone to make an investment—it’s how much someone needs to make it worth it in their eyes. The expected return, or how much is expected to be made, must be at or above the required rate of return for an investment to be seen as “worth it.” The return on investment, or actual return, is how much they end up making.
Many things can influence a person’s required rate of return, like expected inflation or tolerance for risk.
Inflation and the Value of Money
Inflation is the increase in the general price level of all goods in the economy. This is not to say that every price increase is inflation—the prices of goods throughout the economy have to rise.
Usually, inflation each year sits at a couple percentage points, meaning that the prices of just about everything are due to rise about 2 to 3 percent per year on average. This is typically caused by expanding the money supply, usually by the government printing more money so everyone has physical money to use even as the population grows. When everyone has more money, businesses will typically raise prices to reflect this. The government tries to keep inflation at this level since it is often seen as the most effective way to get people to spend their money in a reasonable amount of time after getting it and to circulate it throughout the economy. The government does not want everyone to be able to sit on their money without using it without consequence.
Since people expect inflation to continue, and thus their money will be worth less in the future as prices increase, they are encouraged to spend rather than hold their money. Combined with the time value of money, it makes the most sense for people to use their money in some way to either earn a return or to buy goods while they are cheaper in the present.
In rare cases, deflation can occur. This is the general decrease in prices throughout the economy. Deflation can be thought of as negative inflation. A government might pursue deflation when inflation is out of control, and prices are rising too fast for consumers to use their money effectively. Remember, the government tries to keep inflation slow and steady, just enough for people to keep spending but not too high to where current income and wages become worthless very quickly. Deflation has historically been used in rather desperate situations.
Putting it All Together
With inflation almost always eating away at spending power, and with the potential for your money to make a return by investing it, it makes sense that your money now is worth more than it will be later.
Not only will $100 buy you more stuff than $100 ten years from now, but your $100 can be invested over those ten years. At a 7% annual return, your $100 today would be worth $200 in a decade.
What Should I Do About It?
The time value of money helps to explain why it makes sense to take fixed rate long term loans to buy assets, or why you should delay paying something for as long as possible so long as the price does not increase in order to get the best deal.
If you knew you could invest in something for the same price years from now, it would make sense to invest in something else in the meantime to try and earn an extra return and then buy that other thing.
Keep your money at work! Letting it sit as prices rise is a losing proposition. Your money can constantly make a return so that it is worth more in the future.
Time is money. Your money needs time to grow. Putting it to work allows it to do that.
However, letting your money sit without doing anything risks seeing its value decline with inflation.
Think in terms of returns, or forgone returns, when you make a purchase. Is it really worth buying a car now when you could use that cash to invest in something that will allow you to buy a much nicer car in the future? Always consider the time value of your money as you make your decisions. Many years of potential compound interest might change your mind.