It would be conservative to assume that most of us have heard of the saying “Time is Money”. But how many of us truly understand the significance of this idiom in investment.
What is Time Value Of Money?
Today, the most fundamental of investment concepts would be introduced – The Time Value of Money (“TVM”). If given a choice of receiving S$100 today and S$100 a year later, which should one prefer?
The fundamental principle behind TVM would be that the purchasing power of money varys over time. Money today might have a different purchasing power a year later. The price of food and beverages in Singapore would be the perfect example of this concept; 5 years ago, S$1 could get one a decent glass of ice milo. Today even in the heartland coffeeshops, a glass might go for close to S$2.
This phenomenon is affected by both inflation and interest rates. Our focus would be primarily on interest rates today.
Why Should One Lean Towards Receiving S$100 Today Instead Of S$100 A Year Later?
One reason would be that the money received today can be invested to generate more money; hence S$100 invested at 5% per annum today would result in S$105 a year later. For now, we will skip the other risks such as default risk (The risk that the other party doesn’t give you that S$100 a year later) and inflation risk.
The core principal of finance assumes that, provided money can earn interest, any amount of money is worth more the sooner it is received due to its potential earning capacity. One can see it as a compensation for later gratification, by not splurging on that bag now; you could potentially reap the rewards in future.
How Does Present Value & Future Value play into this?
Present Value: An amount today that is equivalent to a future amount discounted by an appropriate interest rate over a specified period of time
Future Value: The amount of money at a specified date in the future that is equivalent in value to a specified sum today
Given our earlier example, S$100 is the present value today and given a 5% interest return per annum, our future value would correspond to S$105.
For simplicity sake, we would only be going through a one year period without the consideration of compounded interest. It was alleged that Albert Einstein mentioned that compounding was the “8th wonder of the world”, but that is a tale for another time!
Value In Action
TVM is the cornerstone of investing, where we choose to forsake instant gratification in the hopes of a better future. The above clearly demonstrate that time is literally money and this simple piece of knowledge would definitely serve you well in prioritizing your investments in the future!
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The information provided is for general information purposes only and is not intended to be any investment or financial advice. All views and opinions articulated in the article were expressed in Cheong Mun Hong’s personal capacity and do not in any way represent those of his employer and other related entities. Cheong Mun Hong doesn’t own shares in any companies mentioned above.