Financial Literacy Friday: The Time Value of Money

Welcome back to this week’s edition of Financial Literacy Friday where today we’ll be focusing on the time value of money.  This can get into the weeds a bit if we delve into the actual mathematical functions, so let’s start with a simple definition and go from there.  The concept of the time value of money basically means given the choice between receiving the same amount of money today or in 5 years, it’s better to receive it now due to compounding and opportunity cost.  We’ll look at how both of those concepts play into the time value of money, and why it’s better to save and invest now than down the road. Let’s start with opportunity cost.

Opportunity Cost

Simply put, opportunity cost is the benefit that you miss out on by choosing one alternative over the other.  To put this in perspective, if you have $1000 you can put that money into a savings account or invest it in stocks or bonds.  A savings account will give you a small amount of return, but you’re going to get it. The investments may generate a far higher return, but there’s a chance you could lose money.  The opportunity cost is what’s lost in deciding one way or the other. So, how does this relate to whether you should get money now or later? By receiving money now, you have the ability to use it to generate returns either through investments or through interest rates in a savings account.  By waiting for 5 years to get the same amount, you’ll have that same base amount but will be lacking 5 years of growth. The sooner you’re able to put your money to work for you, the more money you’ll be able to generate throughout time.

Compounding

Albert Einstein once said “compound interest is the eighth wonder of the world.  He who understands it, earns it...he who doesn’t...pays it.” Compounding is what makes the concept of the time value of money so important, and why it’s better to start early.  If you receive the money now and just put it into a savings account, you’ll be generating interest every year. That will compound, so if you have $1000 at 1% interest for the year, at the end of the year you’ll $1010.  Next year, that interest rate will be applied to the new account balance of $1010 and will generate a bit more interest, and that will go on and on. If you invest it, the returns will likely be higher, and that will compound as well.  That’s why getting money now is the better choice as you’ll be ahead of where you would be if you got the same amount in 5 years. Compounding is such a powerful force and it allows you to put your money to work for you, as oppose to the other way around.

Start Now

All of this leads to the conclusion that starting now is far better than waiting.  Even investing $50 a month in an IRA or other investment account is going to be more advantageous than waiting until you feel ready to start saving for retirement or creating a robust investment account.  I’m not advocating taking every spare cent and throwing it in the stock market because that’s unreasonable, but most people could find an amount that they could put away every month without negatively impacting their lives.  If you’re very risk averse, start with something like a savings account as that will at least get you in the habit of putting away money and help build good financial habits. It’s certainly important to invest throughout your lives and as you grow in your careers you’ll have more assets to allocate this way, but starting early can be a huge step in creating long term financial success.  

If you have questions or comments, leave them below or reach out through email and I’ll be happy to go into more detail or chat about any concerns you may have.