Understanding the Time Value of Money: The Best Time to Invest for the Future
I would like to propose a hypothetical situation to you:
You wake up one fateful day to find out that you have been selected as the winner of the state lottery. Instantly a sense of excitement, and a bit of anxiety, rush over when you learn that you will be receiving $100 million. This money will likely change the course of the lives of yourself, your family, and those close to you.
However, there is a catch.
You are then informed that you have two options regarding how you would like to receive your funds. Option 1 would allow you to receive the entire lump sum of $100 million today as a direct transfer into the bank account of your choice. Option 2 would allow you to receive $105 million 1 year from today, with the extra $5 million dollars being viewed as interest from the state for delaying payment.
You weigh your options and decide ultimately that regardless of which option you choose you will be receiving at least $100 million. You remember that since interest rates are at all time lows, and likely to stay that way for the foreseeable future, that you can likely borrow against this money in the future. You often see headlines citing how the stock market has been reaching all time highs in recent days, but you don’t look into it any further. Along with this, you understand that it doesn’t take a genius to realize that 105 is greater than 100. Thus, you decide to go with option 2 where you would receive $105 million in 1 year.
You can now sleep soundly knowing that you will likely be a multimillionaire for the rest of your life. Yet, as time goes on, you cannot shake the fact that you feel you may have somehow left money on the table.
How could this be?
This hypothetical situation is a great example of the Time Value of Money (TVM), which is one of the core principles that virtually all financial markets and transactions are based on around the globe. The logic behind TVM is as follows:
Any sum of money is always worth more today than that same sum of money in the future.
Another way to think of the TVM is from the stories we hear from those older than us. Decades ago you could purchase a candy bar for 5 cents each. Nowadays, that same candy bar might cost you close to $2. How can this be? To put it simply, it is because of the TVM. As time moves on, the value of one unit of currency changes which is why $1 today is vastly different from $1 in the 1950s.
Let us return to our previous hypothetical situation. Was option 2 the correct choice? In this instance, and in most, option 1 would have made more sense. How could this be the case? Simply put, because of the Time Value of Money. Under the circumstances of option 1 you would receive $100 million today, which you could very easily invest this into the market. Assuming you invested it into a vehicle that tracks the S&P 500 for example, which we may dive into at a later date, then you could likely receive around 7-10% in return on an annual basis.
After investing this $100 million for 1 year you could easily have close to $107-$110 million invested after 1 year, where option 2 would leave you with only $105 million at the same date. Thus, it would make more sense to actually take option 1, receive your $100 million, and invest it into the market than to take option 2.
So, all of this begs one simple question: when should I invest my money?
Well, to be clear, what you should invest in is a topic for another day. Yet, as we have learned, the best time to invest is today. Right now, and not a second later. Our money loses value over time, and by investing today you begin to fight back against this slow loss of value in your wallet.
Again, discussing what you should invest in is a topic for another day. However, my hope with a short example is that you can see that the best time to begin investing is not in the future, when it's convenient, when you get that bonus, or when the market takes a dip. The best time to invest is right now, today, and we can see this through the power of the Time Value of Money.
By: Daniel Trentham, Marketing Coordinator at CROFT & FROST