Time value of money
This is a concept that all investors should understand and even if your not an investor it's in your best interest to at least know about it. Time Value of Money(TVM) relates to the buying power of money through the past, present and future. In simple terms: Money from yesterday is more valuable than money today and money today is more valuable than money tomorrow.
TVM and compounding dividends go hand in hand. Money that receives interest/dividends payed out, once reinvested, allows for a bigger capital allowing for a bigger growth and a bigger dividend/interest the next time. The time value of money effect is small over the short run but large over the long run.
The following graph shows the decay in money value as time goes on.
As you can see in the graph above, as time proceeds the value of money reduces significantly at different inflation rates. This is one side of TVM, but there is also another side.
The following graph shows the increase in the value of money invested as time goes on.
As you can see once money is invested the value increases year after year and the higher the interest rate at which invested the higher the change year on year. This is TVM
Why is Time value of money(TVM) so important for young Investors and adults/teens.
Since you know now how time value of money works, it is time to explain to you how import it really is. As Investors and young adults we often get caught up in short term "gratification", something that feels good now but is actually not good in the long run. It is essential than we understand the total value of these "gratifications".
Young adults have the tendecy to focus on clothes, drinking and spending money on consumables. As great as some of these things feel they don't really add much value to our lives. Yes you can argue that emotional well being is very important and I agree on that, but that doesn't mean you need to spend all your money on a night out. I get it "I'm only young once" and yes this is true, but you still have the rest of your life ahead of you and by saving or even better investing you ensure that you still have a good life till the end of your days.
Lets say for instance, you spend R1000/$100 extra every month on things you don't need, that's R12000 p/y or $1200 p/y, that just goes down the drain. But if you invest that amount or save that amount it becomes way more. Lets take some rough estimates. A savings account with a 3% p/y return and a ETF that invests in the S&P 500(the last two years of growth in the S&P 500 is 82% thus 41% p/y, but lets reduce it a little to 20% p/y).
| USD (p/m) | ZAR (p/m) | Savings(%) 1 | Investment(%) 2 | Investment(%) 3 |
|---|---|---|---|---|
| 100 | 1000 | 3 | 20 | 41 |
Using the formula below we can establish what the amount will be like in a years time. This calculation will be done based on a single deposit of the full amount($1200/R12000).
FV = PV x [ 1 + (i / n) ] (n x t)
- FV = Future value of money
- PV = Present value of money
- i = interest rate
- n = number of compounding periods per year
- t = number of years
| Month | Total before interest | Total after interest | Total interest |
|---|---|---|---|
| USD 1 | 1 200 | 1 236.50 | 36.5 |
| USD 2 | 1 200 | 1 463.27 | 263.27 |
| USD 3 | 1 200 | 1 795.84 | 595.84 |
| ZAR 1 | 12 000 | 12 364.99 | 364.99 |
| ZAR 2 | 12 000 | 14 632.69 | 2632.69 |
| ZAR 3 | 12 000 | 17 958.40 | 5958.4 |
As shown by the tables above, these are the amounts of interest added to you money, or if not invested, the amounts of money you lose by not investing.
How to adjust your spending
As indicated in the tables above you lose out on quite a bit of money if you don't invest/save, but how do you go from spending to saving. It's not always easy aspecially if you're used to it and it's a routine in your life, but the key is to start small. Each month start by putting away a small part of you money if you don't do it already, reduce your wants by 25% percent and move that 25% to needs, saving/investing.
With time it will become easier and even second nature, this will make it much easier to save/invest, this is when you start increasing the amount form 25% to 40%/50% and so on. Eventually you'll have enough invested/saved, but the longer you leave it the better, and before you know it you'll have more than enough to be at ease with life.
If you'd like to read more about value investing read the article below by investopedia.