Money today is worth more than tomorrow.
One way this shows up in our lives is through inflation. Because of inflation, my dollar today will buy more now than it will buy me in the future.
As we have seen recently at gas stations, grocery stores and car dealerships, inflation affects everything. Inflation is a rise in prices, which can be translated as the decline of purchasing power over time. Now, with inflation averaging 3.8% per year from 1960-20211, we know that our dollar is worth less every year. This is why investing is so important!
Over time the stock market beats out inflation. So, if you put the same amount of money in a savings account and an investment account, the money invested would be worth more than the money sitting in the savings account.
Let’s look at an example:
| Savings Account | Investment Account |
Initial Investment (month 1) | $500 | $500 |
Monthly Investment (month 2 and after) | $500 | $500 |
Average Rate of Return | .06% | 8% |
Amount after 5 Years | $30,044.29 | $36,738.43 |
Amount after 10 Years | $60,178.85 | $91,473.02 |
Amount after 20 Years | $120,719.85 | $294,510.21 |
Notice how leaving the money in the savings account after 5 years only yields $44.29 in interest while the investment account yields $6,738.43. That is a big difference. Also, because of inflation, the yield on the savings account is actually worth much less than what you started with. You are actually losing purchasing power by putting it in the savings account.
One concept that is used to fight off inflation is compound interest, which is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods. This is particularly important for young people as time is one of the key factors and young people have a lot of it.
From the example above under the investment account, we see compound interest working its magic. The calculations are comprised by multiplying the initial investment (or principal) by one plus the annual interest rate raised to the number of compound periods.
For all my visual and technical learners:
FV=PV(1+r/n)n
FV = future value
PV = present value
r = interest rate
n = number of compounding periods
But this is only if you were to put in the initial investment and nothing more. Once you start adding more and more on systematic basis, the formula changes a bit. See below:
FV=PV(1+r/n)nt+((PMT(1+(r/n)nt-1)/(r/n))
t = number of years
PMT = Regular contributions
When we add the “t”, compound interest can exponentially grow, and this is where the younger generation can capitalize on the number of years they have until retirement. The addition of PMT is to show the additional money added to the investments on a regular basis.
For a great interactive compound interest calculator check out NerdWallet’s calculator here!
Taking Things Into Perspective
When it comes to spending money on discretionary things, the time value of money should be something that is considered as an opportunity cost.
Take for example a cup of Starbucks coffee that costs $6 dollars. If I were to brew my own cup of coffee at home for $1 and invest the difference of $5 for my retirement (on 8% annualized yield over a 30-year period), that $5 would be worth $50.31. It does not sound like much but if I increased what I am saving from $5 to $100 (20 cups of Starbucks coffee), then I would have $1,006.27. If you save this on a monthly basis, with the effects of compounding interest for 30 years, you would have $149,035.94.
I hope this blog post has put many ideas and concepts into easier and more understandable terms so you can implement them into your own life. By no means is this the full explanation of time value of money, inflation or compounding interest. This blog post would be an hour long read if it were. But if you have any questions, please do not hesitate to review or consult Tori and Alex.
- https://www.worlddata.info/america/usa/inflation-rates.php#:~:text=The%20inflation%20rate%20for%20consumer,the%20price%20increase%20was%20829.57%20%25.