Would you rather have £100 now or £100 in one year? Most would choose the former, but not all would know why.
So what about this instead: would you rather have £100 now or £105 in one year? Your answer will depend on two things:
- If you saved or invested the £100 today, how much money would you have after one year?
- How much has the general price level of goods and services that you might want to buy in one year changed?
The first factor depends on the rate of return you could realistically earn on your money. You can assume whatever you like, but to get a proper understanding of the time value of money, it’s best to be realistic, which often means being conservative. Let’s assume for now that could earn about 1% interest per year by saving that £100 in a bank account today.
The second factor reflects the possibility that a basket of shopping, for example, which costs £100 today, may cost or more or less than that in the future. This is inflation. Let’s assume inflation is about 2%.
So, £100 today will turn into about £101 in a year, while at the same time, you lose £2 because prices have gone up by 2%. That leaves you with £99 in a year. Clearly, the choice of receiving £105 in a year is much more attractive than receiving £100 now. In fact, in this example, even receiving £100 next year would be preferably, because inflation is higher than the interest rate, or realistic return on your savings.
The time value of money concept is important in countless ways. It pervades a lot of basic and complex analysis at investment management and investment management companies, but it’s also important for day-to-day planning for the everyday person. Equating savings goals with spending requirements, planning for wealth, deciding whether to pay upfront or in instalments… the list goes on.
The time value of money is a concept that features – explicitly or implicitly – in many of our articles. It is a fundamental concept that should eventually make its way onto your ‘second-nature‘ list of abilities, along with driving a car or riding a bike (although riding a bike is far from second-nature to this author). We’ll try and be clear when the concept is important in an article, to help you with getting comfortable with it.
We refer to lots of linked posts in this post. We hope that by following the links you can answer any questions you might have, but if anything is unclear in this post, or you have any questions relating to anything investment-related, please submit comments or questions in the section below and we’ll do our best to answer them.
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To the pound 