The Christian Bible tells the story of a master who gave each of his servants a quantity of money. The servants who invest the money double theirs, while the servant who buries his gets nothing— as well as an upbraiding from the master. Even in antiquity, people understood that money had time value.
What does time value mean? It means that money available at a certain time is worth more than the same amount later. You can’t trade ten dollars next year for ten dollars now. No one will take that trade, because they lose the time value of that ten dollars.
What could you do with $100,000 over the next five years? You could start a small cottage business. You could buy a home, or renovate one. Or you could invest it in stocks or bonds. Each of these could increase the starting amount, so that in five years you could have $150,000; $200,000; or even more.
Knowing the options you have for increasing the value of your money over time, what would someone have to pay you to pass that up? What amount of money would you want to receive in five years to make it worth the same as $100,000 today?
The difference between these two numbers is the opportunity cost— the lost opportunities you might have for investing that money over the next five years. Any investment you make has an opportunity cost. For instance, if you buy a house with your money, you can’t also invest the same money in the stock market.
A small example we all deal with is tax refunds. If you set your withholding high, you’ll get a higher refund. But that amount will come next spring. You pay the opportunity cost of whatever you might have done with that money now. If, instead, you set your withholding as low as you can while still covering your tax liability, you can put that money to work for you during the year.
How to Calculate the Time Value of Your Money
Say you have a certain amount of money now, and you want to know what it will be worth in the future. What variables do you have to take into account?
Your rate of return is the most important factor. Not everyone has the same options for investing their money. For instance, if it’s a small amount of money, you can’t start a business or buy a house, but you might purchase a certificate of deposit or a bond. What potential investments could you use the money for, and what is the expected rate of return for each?
How much time do you plan to invest it for? What is the end time when you want to know the money’s value?
Is interest paid monthly or annually? If you want a really precise number for the time value of your money, the compounding period can be relevant.
What is the current inflation rate? Will your money lose value faster than you are investing it? That can sometimes be the case with low-yield investments, such as the interest on your savings account. If you want the full time value of your money, you should invest it somewhere you can earn more than it loses through inflation.
How It’s Used
Calculating the time value of money, in a certain investment, is a great way to find out how good a specific investment is. The rate of return isn’t enough— you also need to know how much money you’ll actually have at a given date in the future. Using the variables above, financial advisors and investors can simplify an investment’s possibilities into a single number.
Time value of money is also used in discounted cashflow analysis. This is a common tool used by investors to figure out if an investment will pay off. They estimate the future cash flow of the investment and compare that to the present value of the money that could be invested in it. Only by factoring in the time value of money can they get an accurate analysis of the investment’s value.
Are You Putting Your Money to Work?
As you can see, hiding money in a hole or leaving it in a low-interest bank account is costing you opportunities. Even small amounts of money can grow if you invest them. To find the right investments for any budget, contact us to reach an experienced financial advisor.