Unravelling the Concept of the Time Value of Money: Its Implications and Applications
If you are an investor, understanding the concept of the time value of money and its implications could be key to clock better ROI. Time Value of Money (TVM) is an important concept in economics and finance that stresses the idea that one dollar today is worth more than one dollar tomorrow. This article will guide you through the basics of TVM, shedding some light on how it works, what its most common applications are and how you can use it as an investor to make better economic decisions.
What is the Time Value of Money?
The time value of money (TVM) is a fundamental economic and financial concept that emphasizes the importance of receiving a sum of money now instead of an equal amount in the future. The concept of the time value of money is a fundamental principle for financial planning, as it highlights the importance of investing and getting a return on investment. Essentially, the value of money today is greater than its value in the future, due to factors such as inflation and potential investment growth.
For example, in a hypothetical scenario where you loaned $1,000 to a friend, and they're offering to repay you now, or they'll repay you the same amount after they return from a year-long trip. The TVM concept suggests that it would be wiser to collect the money now. During the course of the year, you could put the $1,000 into a high-interest savings account or invest it wisely to make a profit. Moreover, inflation would decrease the value of money in 12 months, meaning you'll effectively receive less in real terms.
A pertinent question would be to ask how much your friend should pay you in 12 months to make waiting worth the while. They'll need to offset potential earnings you could make in the 12 months waiting period.
What are Present Value and Future Value?
Present value refers to the current worth of a future sum of cash after it has been discounted using the market interest rate. For example, you may want to know what the $1,000 you'll receive from your friend in a year is worth today.
Future value is the opposite and calculates a current sum of money's value in the future at a given market interest rate. So, the future value of $1,000 in a year would comprise a year's worth of interest.
How do Compounding and Inflation affect the Time Value of Money?
Compounding
Compounding has a snowball effect on your money as it grows, as you earn interest on both the principal and accumulated interest. In contrast, with simple interest, your money accumulates interest at a steadier pace.
Inflation Effect
Inflation also affects the time value of money and should be considered in your calculations. For example, a 2% per annum interest rate doesn't protect your capital if inflation is at 3%. When negotiating wages or making long-term financial decisions, it's essential to factor in inflation.
Inflation can be challenging to measure and predict, and there are various indexes to choose from when calculating the increase in prices. You can build a discounting aspect for inflation into your financial models, but keep in mind that it can be unpredictable.
Time Value of Money and Crypto Investments
Locked Staking
In the world of crypto, you often encounter situations where you choose between a sum of crypto now and a different sum in the future. One example is locked staking, where you must decide whether to keep a crypto asset now or lock it for a certain period and earn interest. By performing simple TVM calculations, you can identify the most lucrative staking opportunity.
Bitcoin Acquisition
Another common example is deciding when to buy Bitcoin (BTC). Despite being called a deflationary currency, its supply increases slowly up to a certain point, making it inflationary in the short term. When deciding to purchase $50 of BTC, TVM suggests it's better to buy immediately.
Last updated