Some people put their money in a bank account; some make investments in stocks and bonds. Different people follow different strategies to keep their money on the move. All of them consciously or unconsciously realize time is the biggest enemy of idle money. With the passage of time, money lying under our mattress becomes worthless pieces of paper. So, the concept of time value of money always influences our decision about what we intend to do with our money.
Jinny: Hi, Johnny! I see you are lost in a daydream. What are you thinking about?
Johnny: Well, I was wondering what makes a rupee in our hands today worth more than a rupee tomorrow. Tell me, what is so different about currencies made of paper that the value of the same amount of money diminishes with time? After all, the value of other things made of paper does not diminish with time. The value of tissue paper would not become less even if we decide to store it for five years.
Jinny: Well, you need not be a philosopher to understand the concept of time value of money. A Rs100 note today in our pocket is worth more than a Rs100 note that we may get after five years. All of us intuitively know that. But let’s try to understand what actually makes the present value of money worth more than the value of the same amount of money after five years.
Money, as you know, is just another name for new opportunities. You can use tissue paper for just one purpose but the money that you have now can open the doors for many opportunities. Different uses of money may have different advantages. Some of these opportunities may look very small but some of them might really put you on the fastest track to the future.
If you invest your money now, you would earn a return which would make your money grow in the next five years. But the problem is you can choose only one of the many equally advantageous opportunities. All of us try to use our money for the best possible opportunity.
Illustration: Jayachandran / Mint
The advantage that we forego by not putting our money in another possible opportunity is what we call, in technical terms, the opportunity cost of money.
So, if you are investing your money in a 10-year bond that pays you 10% interest, then you are foregoing an opportunity of putting the same money in a 10-year term deposit that pays you 8% interest. In this case, your actual advantage is only the 2 percentage points more interest that you earn on your investment in bonds. But always remember that different opportunities have different risks. Investment in bonds may be riskier than investment in term deposits. So you should always compare the risk-adjusted return to find out whether you are gaining or losing in making a particular use of money.
Johnny: But what if I decide to spend my money now or keep my money idle instead of making any investment?
Jinny: If you decide to keep your money idle then you are making zero gain and so you pay in terms of lost opportunities. Spending your money now is a better option than keeping it idle. By spending our money now we could purchase many more goods and services than we could purchase with the same amount of money after five years. This is so because the purchasing power of money keeps on decreasing due to the rising cost of goods and services. It is better to eat your breakfast before inflation eats your money.
Today you can buy four pastries for Rs100, but maybe after five years you would be able to buy only two. So you have to think—if I give you an option of either taking four pastries today or two pastries after five years, which option would you choose?
Johnny: Obviously I would like to take four pastries now. But tell me, how can we use the concept of time value of money to make intelligent decisions about our money?
Jinny: The first thing you must keep in mind is that you should never keep your present money idle. Money has to grow with time. Keep it in a bank account or invest it in stocks or bonds so that the return is good enough to at least preserve its present value. Before making an investment, always try to figure out what its worth would be, say, after 10 or 30 years, given the present rate of return.
If you invest Rs1 lakh now, what should its worth be after 30 years if you are earning 10% return per annum compounded annually? You can very easily know the answer, provided you know how to calculate compound interest. For your knowledge, let me tell you that Rs1 lakh would be worth Rs17.45 lakh after 30 years.
Johnny: Sometimes, Jinny, I wonder whether you have a computer inside your head. I will ask you about how to calculate the present value of future money next week.
What:The concept of time value of money says that the value of money at present is worth more than the same amount of money in the future.
How: By making appropriate investment decisions, we can make money grow with the passage of time.
Why: Two factors play an important role in the time value of money—loss of investment opportunity and rising cost of goods and services.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at email@example.com