If you were offered $1,000 today or $1,100 a year from now which option would you take? If you chose $1,000 today you would be correct. If you choose to wait a year and be guaranteed an extra $100 you could be losing money. Today I want to walk through why time value of money is so important especially when it comes to investing.
What is Time Value of Money?
Time value of money is simply a dollar today is worth more than a dollar tomorrow or a year from now. The opportunity cost of money now allows you to take your money and grow it today, rather than waiting for it in the future.
This means you could take that $1,000 and invest it gamble it etc. and it could be worth more in the future.
How we find Time Value of Money
To understand time value of money we need to do some math. First we need to know a few key terms:
FV= PV*(1+(I/N))^(N*T)
(FV) Future Value- assumed value of money at future date
(PV) Present Value- current value of money today
(I) Interest- Rate at which interest is paid
(N) Number of Compounding Periods- payout periods per year
(T) Time- Number of years
This formula is super important because it allows us to determine what the assumed future value of money will be. This formula is not accounting for inflation however we will assume inflation to be 0%. If we go back to our original question would you take $1000 today or $1,100 one year from now, we can see which option is better.
We start with the present value which is $1,000 given to us. We then plug in
the interest rate, which is assumed 10.5% based on the average return of the S&P 500 index. The S&P 500 is an index of the 500 largest publicly traded companies. In this case we are calculating for a full year which is why (T) Time=1. There is only one payout period within that 1 year which is why (N) Number of periods=1. Assuming we invested today, one year from now our returns could equate to $1,105. We could earn $5 more in the future if we took the cash now and invested it.
Inflation
Inflation is the decline of purchasing power of a currency over time. We know that there is usually some sort of inflation hence why prices go up. One way we can measure inflation is based on the Consumer Price Index (CPI). The CPI is measures how much goods go up or down year to year. Using data from the BLS.gov we can calculate the average inflation rate over the past 10 years to be 2.1%. In this next example we will add inflation into the mix.
The problem stays exactly the same as the first example. This time we just added inflation into the mix. Now that we know what the future value is, we simply multiply by the inflation rate to come to our inflation adjusted value.
Why it matters
We all want to grow our money, but many don't know how important it is to start early on. This equation shows how important it is to start investing sooner rather than later. Although we didn't equate for it in the formula dividends are also payed out in most S&P 500 stocks. This dividend payout can be used to acquire more shares or even partial shares. If we were to include that in the formula we could potentially grow that money faster.
Talk to a Financial Advisor
When it comes to investing it is always great to speak with your financial advisor first. A financial advisor can help build you a savings plan to make sure you are set up for financial freedom. An advisor can walk you through step by step setting up the right retirement plan for you.
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