If the richest person in the world offered to give you €1,000 and you had the choice of either taking the money today or one year from today, what would you do? Well, there is a right answer to this question, and the answer is that you should take the money today.
Why? Because of the core financial principle called the Time Value of Money (TVM). Essentially, any amount of money is worth more today than the same amount of money at some point in the future. This is due to multiple reasons that we explore in this lesson.
Time is Money
If you think like most, you would have chosen to receive the €1,000 today instead of waiting for a whole year. And that would be the better decision to make. TVM is a basic financial concept which allows you to understand what your money is worth in terms of time. Time can considerably affect your wealth if you don’t manage it correctly, and the concept of TVM determines the magnitude of that effect.
How come €1,000 today is worth more than €1,000 in one year? Isn’t it exactly the same? No, it’s not the same, and this is mainly because of the potential to invest that €1,000 today and grow it until next year. Another reason is inflation. The concept of Purchasing Power. The things you can buy today with €1,000 will most probably (not certainly because sometimes inflation is negative) be more than the things you can buy with €1,000 in one year’s time.
Inflation and Purchasing Power
The cost of basic goods such as bread, milk and coffee has increased by multiple times in the last 50 years. This is a direct effect of inflation which defines this general increase in prices across time. Inflation diminishes the buying power of you as a consumer and is another factor to consider when searching for appropriate investments to include in your portfolio.
Most consumers in an economy are victims of inflation since they choose to save all of their money instead of investing at least a portion of it. When all your money sits in a savings account or under the mattress, it earns no interest, losing some of its value across time. In the last 50 years, the average inflation rate in the European Union was approximately 4.4%. Therefore, if you chose to stack your money under the mattress for the last 50 years, your money would have lost approximately 90% of its purchasing power. That is a significant amount, and it is a key factor for why you should consider investing and growing your money over the long run.
As a result of the continuously increasing prices, it is essential to keep moving forward instead of standing still. For example, if your savings in the bank are earning an annual interest of 2%, but at the same time the inflation rate is at 3%, you are effectively ~1% poorer each year. On the other hand, if you invest your money and earn 5% per year, despite the 3% inflation rate, your wealth increases by ~2% each year.
What do all these mean for you? It’s not viable to keep all your money in the bank and expect it to grow or even keep its worth. Instead, if you wish for your savings to grow, you need to invest at least a portion of them.
Making your Money Work for you
Returning to our example from above, by choosing to receive €1,000 today, you are in a good position to grow the Future Value of your money by investing it and having compound interest work for you over a period of time. If, on the other hand, you choose to receive the €1,000 in a year, then time is working against you.
Below we explore two scenarios. In both scenarios, we assume the inflation rate for the next 10 years is going to be 2% annually. In Scenario 1, we assume your money is in a savings account earning 0% interest, and in Scenario 2, we assume your money is invested, earning on average 5% every year.
From just a 2% inflation a year, Scenario 1 shows that in 10 years, you will lose approximately 20% of your purchasing power if you do not invest your money. Scenario 2 shows that by investing your money and earning just a 5% return a year, you will grow your real wealth by more than 30% in 10 years, even if you account for inflation.
Wealth begets wealth. Or, as we say in Greek, τα λεφτά πάνε στα λεφτά. One of the reasons for that is the time value of money. Having money in your pocket now means you have an opportunity to grow it. Make it work for you. If you delay investing your money, you not only lose the opportunity to grow it, but your real wealth declines too, thanks to inflation.