My main ambition with this blog is to break down more advanced financial concepts into small bite size pieces. Knowledge is power. And building that financial savvy, will help you advance towards your goals. Or at the very least, you’ll be able to understand why you are not reaching your goals. Today I tackle the topic of “Time Value of Money”.
I addressed net worth calculations and savings rate a couple of posts ago. Feel free to check out those posts if you’d like to learn more. And if you are familiar with the concept of “Time Value of Money”, I’d say read along and pitch in the comment section.
What is the “Time Vale of Money”?
Time Value of Money or TVM for the initiated (by the way… you just got initiated 🙂 ) relates to the concept that money has a different value over time. And the value of money only means something when it is placed in context of time. A quick example:
Imagine I have 100 euro and I give you a choice: You can have 100 euros now or I can give it to you in a year. What would you choose?
About 99,99% of the people would take that money immediately, demonstrating that those same 100 euro are worth more to us now, than they are in 1 year.
Why is this?
There are a number of reasons why the value of money differs in time but the main ones are these:
If I promise you a 100 euro in a year, you are taking a risk. Chances are I won’t be around in a year to hand you that note. So at the very least you would ask me for a bit more than 100 euro to compensate for the risk you’re taking by not pocketing those 100 euro immediately.
2. Cost of opportunity
If you choose to wait for a year, you forego the opportunity to make some cash with those bucks. You could put them in a savings account or checking account and get a little return from that. So you should ask for some compensation for that too.
Finally, things get more expensive all the time. Remember how much a bread cost when you were a kid? Exactly! crazy isn’t it? That’s what inflation does. You would literally be able to buy less stuff with 100 euro a year from now than today. Again, if you were a completely rational person you would ask compensation for that.
Those three factors are the main reason money has a different value in time.
What does Time Value of Money mean for you?
This would be pretty useless theory if this had not real implications on how to manage your personal finances.
1. Watch your cash-cycle
I just used a very fancy word to say: get payments as soon as possible and make payments as late as possible.
A few examples:
- If possible adjust your tax contributions so that you are getting a smallest amount back on your tax returns. A big tax return from the government isn’t a gift. Basically they used your money for a whole year for free and then decided to give it back to you.
- If you are a business owner it is smart to ask for advances for work performed or negotiate terms of payments that are as short as possible. Alternatively, you should negotiate to make outgoing payments as late as possible.
- Pay bills on the last day due and manage cash accordingly.
Side note: theoretically this is correct, but don’t use it as an excuse to be late on bills. For 80% of people it makes sense to have all bills paid as soon as they arrive.
2. Invest your money
Inflation makes the value of your money go down year after year. By not investing, you are not adding returns to your stockpile and so that money will become a little less valuable every single year. In the chart below I calculated what 1 million euro would be worth over time if you simply hold on to it in cash without adding returns. At an inflation rate of 2% a year over a 20 year period that 1 million euro will have the same purchasing power as 667 608 euro today.
3. When making financial decisions, use the same time frame
This might sound confusing. But sometimes we need to make financial decisions with events happening at different times. Imagine you could choose between an investment that pays you 1 000 euros in 1 year or 1 500 euros in 3 years. Which is best? In such case you would calculate both sums of money in today’s value. This process of calculating the future into today’s money is called “discounting”.
By the way: the answer in the example above … depends on the rate of discount you use.
How do you calculate the time value of money?
Of course you can find a calculator online, but I think that it is worth mastering this skill yourself. This way you won’t be confined to the limitations of any calculator, but you can solve your financial dilemma’s yourself.
Also, think about the impact you make with your banker or insurer when you can come to a meeting with a graph or two and some calculations and ask the questions that matter. This has been so helpful for me to not be talked into products that were really not suited for me, but kept the bankers pockets fat and stacked. Oh, the joy when you can turn those tables around.
Any spreadsheet will do. I choose to use Excel. The two main concepts you need to grasp in discounting money are:
Present Value of Money
As in : what is the value of money today? of course you know that, but what would be the present value of a sum of money in the future? What is the present value of an investment that generates you 1 million euros in 5 years? Now reading about how to do Excel is not super exciting, so maybe you will prefer this video on how to calculate PV in Excel. It’s among the best I have seen and if you are unable to calculate a PV now, you should have a better grasp after this video.
Future Value of money
As in: What amount can you expect in the future if you invest now? If you invest 1 000 euro today, how much could you expect to have in 10 years if you invest that in a fund? What would be your future expected value (FV). Also here I thought this video on how to calculate FV in Excel would be easier on your eyes :-).
Time is money
Time and money are inextricably linked. And as such money is time and time is money.
What is your opinion?
Do you have any thoughts or an opinion you would like to add? Do you use this concept in your financial decisions? Join the discussion in the comment section.