What Every Investor Needs to Know About the Time Value of Money
Understanding the concept of the time value of money (TVM) will transform the way you think about money and profits.
Investors are always overheard discussing numbers, but savvy investors attach the idea of time to these numbers. The truth is, the amount of money in question isn’t the only thing that matters. What also matters is when you get that money, or what it allows you to do now vs. in the future. Having a grasp on how time affects the value of our money will allow you to sift through the best ways to save and make it as an investor.
After all, “time is money.”
The time value of money (also called “present discounted value”) states that the same amount of money is worth more today than it is in the future. A $20 bill in your pocket right now is more valuable to you than finding that same bill in your drawer months from now, simply because of what it allows you to buy or do today vs. later.
A dollar to investors shouldn’t been seen as just a dollar; it’s a dollar with the potential to be more than a dollar over time.
What is the Time Value of Money?
There are many reasons why the time value of money is important for investors. The three most important are what are known as the three “I”s:
- Inflation: When an amount of currency buys you less than it did previously, you have inflation. Inflation is the reason why you could buy a candy bar for a quarter decades ago, and now they cost more than a dollar. Since inflation directly affects money, investors need to take it into account. Understand that your dollar is slowly losing value, and be proactive about it.
- Interest: Sitting idly and letting inflation negatively affect your money would be wasteful. Investors instead should put their money to work and use the TVM to their advantage. One way to do this is by getting their money to collect interest. Interest is the charge a borrower pays to the lender for using their money. Storing your money in banks or purchasing bonds are common ways to collect interest with your money. For example, let’s say you put the $20 you found in your pocket into a checking account that offers 2% interest. By year’s end, you’ll have $20.40. This amount may seem small, but it’s still more money than you started with. You’ve combated the negative effect of inflation with interest. With larger amounts, you’ll do even better for yourself.
- Investments: While interest can make you money over time, the best way to use TVM to your advantage is with investing. Good investors remember that over time the stock market always outperforms inflation. A company’s earnings potential refers to possible profits investors can attain from dividends or stock growth. When you invest in a company, with it comes risk as well as the potential to profit. The tricky part, of course, is finding the right investments. By doing proper research (such as evaluating quarterly reports) you’ll find investments with less risk.
The Opportunity Cost of Time
A principle that smart investors understand when it comes to TVM is the idea of opportunity cost. Opportunity costs tell us that for every decision we make, we’re passing on other choices. Money has many opportunity costs because of the many things we can do with it. For example, when we spend our money we are giving up the ability to invest it.
Opportunity cost gets factored into the time value of money in terms of how we can invest our money. Putting your money into a bank account means you’re passing on the ability to buy a stock that might be a good investment. Opportunity costs and investing go hand in hand, and understanding how they affect each other is the trait of a successful investor.
Opportunity costs even affect those who hold onto your money. Because of inflation, the opportunity cost of sitting on your money is passing on the potential earnings of investing or interest. By not spending your money, there is a cost – that cost is a loss in value.
How to Calculate the Time Value of Money
The equation for calculating the time value of money is too complex to do in your head. It is…
FV = PV x [ 1 + (i / n) ](n x t)
- FV = Future value of money — Which states what your money will be worth after a certain period. The “end amount” that will result from your actions.
- PV = Present value of money — Which states what your money is worth today. Your “starting amount” before you decide what to do.
- i = interest rate — Written as a percentage, this is the rate at which your investment will collect interest. Only input the interest rate if your investment collects interest.
- n = number of compounding periods — The number of periods your interest rate is calculated by. Done often in years, but can also be in quarterly or monthly amounts.
- t = number of years — The number of years your compounding periods collect interest.
Why the Time Value of Money is Important for Investors
While you may be able to plug numbers into the TVM formula, that won’t get you very far. Good investors make sure they understand how they obtained the results they did. See how much greater the future value of your money versus the present value, and see if it outpaces the going inflation rate.
When you change your mindset by seeing money through the lens of time, your entire investing ideology will change. The secret those outside the investing world don’t understand is that our entire financial system works this way.
Money is never static; its value is in constant flux. Having a proper grasp of the concept of TVM can help you better anticipate how companies’ numbers will look in the future. Those who understand the power of this calculation are those who will profit from it.