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.
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:
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.
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)
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.