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In the personal finance community, many people use the concept of Time Value of Money (TVM) to think about money. This concept helps you think about the value of money if it were invested.
I think it is an interesting concept worth talking about. However, we should be careful about using this concept because it leads some people to think too much about their expenses and understanding.
So, let’s see what the time value of money is and what we can do with it.
Time Value of Money
Any sum of money has some earnings potential. Indeed, you could invest this money in the stock market (or in another investment instrument).
The concept of the time value of money means that money has more value now than it has in the future. This means that it is better to receive money now than to receive it later.
When talking about the time value of money, we generally talk about the value of some money in the future, in years. For instance, we want to know the time value of 1000 USD in 10 years or 20 years.
Sometimes, this concept is also called the future value of money since it represents how much some money now could be worth in the future.
Computing the time value of money is relatively easy and is based on the compound interest formula. Here is the basic formula:
TV = V * (1 + (I/N))^(N*T)
TV is the time value of money, V is the current value, I is the interest rate, N is the number of compound periods per year, and T is the number of years.
Since we generally talk about yearly returns, we can simplify the formula with N=1:
TV = V * (1 + I)^T
Now that we know the formula, we can take a few examples.
For instance, 1000 CHF now, with 5% annual returns, has a future value of:
- 1276 CHF after 5 years
- 1628 CHF after 10 years
- 2653 CHF after 20 years
Or, 5000 CHF, with 7% annual returns, has a future value of:
- 7012 CHF after 5 years
- 9835 CHF after 10 years
- 19348 CHF after 20 years
These examples show that money has a large earnings potential if invested properly.
It is important to realize that this time value of money is generally a rough estimation.
If you have a guaranteed interest rate, you should be good with this formula and get exact values.
But when we talk about stock market returns, we are talking about average returns over the long term. The time value of money in a few years makes little sense. But it starts to make sense after 10 years or more.
Also, the stock market compounds monthly, but we never use monthly average returns. So this will make it even less accurate.
Nevertheless, this inaccuracy does not really matter as long as we know this is an estimation.
Finally, when we are talking about the future value of money, we should also consider inflation. So, we should take real returns (after inflation). Otherwise, the amount of money you get will not be representative of your future purchasing power.
And talking about inflation, negative inflation will have the same effect as returns. In that case, the value will be worth more later because of the negative inflation. However, there are few cases of sustained negative inflation, and we should not hope for one.
How to use this concept?
There are several ways to use this concept.
The most important way to use this concept is to realize the value of investing and compounding interest. It shows you that money can grow quickly if kept invested for a sustained period of time.
Another good use of this concept is to decide between several investments. If you have to choose between several investments returning the same amount of money, you should choose the investment that will give you the money the earliest. Indeed, the earliest you get the money, the higher the time value of money it will have.
Yet another great use of this tool is for savings. For instance, if you can save 1000 CHF on some purchases, you are not only saving 1000 CHF now, but you are getting 4321 CHF for your retirement in 30 years (5% returns). This shows that spending less and investing the savings can make a nice difference in the long run.
This is a great tool to estimate how much you are going to save for your financial independence. In the previous example, 4321 CHF could be one month of expense. So, by saving this 1000 CHF, you are giving yourself one more month of freedom. This is not negligible, and this can help see the effect of your savings.
Don’t get carried away
The next use of this concept is where many people get too carried away.
You can use this concept to think about expenses. For instance, a new computer at 2000 CHF has a time value of money of 5305 CHF over 20 years (at 5% returns). And a new car at 25’000 CHF has a time value of 66332 over the same period.
This can help you think about how much you are really spending when considering the future.
Some people use this concept for each expense and think they want to get the future value of money by not spending this amount. If used reasonably, this is a great tool. But if you use that for every expense, you may get crazy and not spend anything.
The most famous example is the stupid example of the daily coffee. If you can save 3 CHF by not having this coffee, you are, in fact getting almost 13 CHF for your retirement in 30 years. If you do that 200 times in a year, that’s almost 2600 CHF you will have at retirement time.
However, if this daily coffee makes you happy or improves your day, why give it up? Will this 2600 CHF at retirement make you happy? That’s unlikely.
So, don’t get carried away with this rule thinking you can’t spend anything. If something makes you happy, do it! But this tool may help you put in perspective an expense right now and what it represents in the future.
You can also use the formula for the time value of money to compute an opportunity cost.
The main form of opportunity cost is the cost of not investing money but letting it rest in cash. So, the opportunity cost of this is the future value of this money minus its value now. For instance, the opportunity cost of not investing 1000 CHF over 20 years at 5% is 1653 CHF (2653 – 1000).
Another opportunity cost is the cost of delaying payment. For instance, starting to work one year later can have a huge opportunity cost. This is why doing long studies may have a large opportunity cost. Of course, people are hoping for higher salaries, but it will still take them quite a few years to go over the opportunity cost induced by getting money instead of now.
The time value of money is an interesting concept that can help think about the real value of money if it is invested. This is a good motivation to invest money early and increase its potential.
However, it is often overused, and many people are driving themselves (and other people) crazy by using this concept at every expense. I do not think it makes sense to apply this concept to a single coffee (or even the stupid daily coffee example).
But it makes sense to apply this to the savings you can make on a big purchase. For instance, when I consider some expense reduction, I sometimes use this concept to see the difference it will make at retirement.
What about you? Have you ever used this concept?