Consider $100 today, and then consider $100 one year from today.
Which has greater value? Is one of those $100 worth more than the other? Do they both have the same value?
Most people would say the $100 today is worth more than $100 a year from now because of inflation, and that's quite a reasonable answer. In our lives there has always been some amount of inflation. We know from personal observations inflation decreases the purchasing power of our money over time.
As a bonus, thinking of inflation also gives you the correct answer to my original question: $100 today is, in fact, more valuable than $100 one year from now. However, inflation isn't the best reason for that fact.
So, let's forget about inflation. $100 today is worth more than $100 a year from now for another reason. $100 today has the opportunity to go to work for a year. $100 today can be invested for a profit. For example, it could be used to buy a bond paying 8% interest per year. One year from today our $100 would be worth $108.
Therefore, time provides opportunity that adds value to money. This concept is known as the time value of money. Simply put, it means a dollar today is more valuable than a dollar in the future. Remember, this is not because of inflation. It is because we have the opportunity to put that money to work. We can use the money we have now to earn more money over time.
It is important to understand this concept. It is the foundation of finance.
The Importance of Time (Oh No, Math!)
Don't worry, I'll keep the math very simple here. I'm not trying to teach a finance class, but I think seeing the formula helps illustrate the role of time in adding value to money.
The value of money now is known as its present value. The value of money in the future is known as its future value. The Present Value (PV) of a sum of money and the Future Value (FV) of that same sum of money can be related to each other through this equation:
Where i is the interest rate (expressed as a decimal)
and n is the time period of the interest rate.
In our previous example we used 8% (or .08) interest rate for a time period of 1 year. Therefore, i = .08 and n = 1.
FV = $100 (1 + .08)1
FV = $108
If we wanted to know the future value of $100 in two years at 8%, then i would still equal .08, but now n would = 2.
FV = $100 (1 + .08)2
FV = $116.64
Note that time (n) in the formula is an exponent. Time has exponential influence over the growth of money.
That's worth repeating: Time has exponential influence over the growth of money.
Also note the formula I am using is for compounding interest. With compunding interest the previously earned interest also earns interest. In our example the $8 of interest earned the first year earns an additional $0.64 of interest the second year. That may not seem like much at first, but the (exponential) impacts over time can be astounding.
Here is a chart of that $100 invested at 8% per year for 40 years. Notice how things start slowly, but after some time has gone by that money begins to grow rapidly. In the last few years it is growing very rapidly. That is the impact of compounding. The more time the investment has had to compound, the faster the investment will grow.
This is why financial advisers preach long and hard about starting to save and invest as early as possible. It is in your best interests to put as much time on your side as you can.
Many people put off saving and investing when they are young and don't start until they are middle-aged. I think that is somewhat natural. It's difficult to start saving when you are younger. Life comes at you fast. There are many pressures in our society to spend more money. You're at the low end of your earning expectations. Kids, student loans, etc. etc. etc. It's tough to save.
It's difficult, but it's also really, really important.
Look back at the graph of $100 compounding for 40 years. If you wait to start saving it might seem like you're just missing out on the first few years – the smaller bars on the left side of the graph. But that is not the case. You are missing out on those huge bars on the right side of the graph. If you wait five years to start saving, peel off the five largest bars on the right. At the end of 35 years your investment is worth just $1369 (bar 35) instead of $2012 (bar 40). A difference of more than six times your initial $100 investment was lost because you waited for five years to start!
Finding the means to start saving now might be difficult, but it is very, very worth it. If you want some help building a plan to start saving now, give me a call. You work hard for your money - let's put that money to work for you!