The time value of money is one of the key concepts you must grasp when investing. Happily, it’s also an instinctive one (though not to be confused with option time value. Nothing is simple with options!)
The time value of money reflects how you’d rather get a fixed sum of money today than exactly the same amount of money in the future. The money in the hand now is worth more than the same amount received in a year’s time.
Which of the following would you prefer?
- £1,000 now
- The promise of £1,000 to be paid in five year’s time
Rational investors would prefer to receive £1,000 today. Five years is a long time to wait. You could put £1,000 received today in a deposit account earning interest for five years. If you got 4% interest on £1,000, then after five years your money would have grown to £1,217. Why choose £1,000 in five years when you could have £1,217?
What about deciding between:
- £1,000 in five years
- £1,000 in ten years
Anyone sensible would prefer to have £1,000 in five year’s time than to wait ten years for exactly the same amount. Thus time value describes a continuum, where a sum of money received now is worth more than the same amount in the future, which in turn is worth more than the same sum at a date beyond that.
How do we calculate the time value of money?
All other things being equal, the time value of money represents the interest one might earn on a payment received today, if held earning interest until a future date.
The fixed income from government bonds is normally used to calculate the present value of a future payment. The income from government bonds is assumed to be a risk-free rate of return.
What if the future payment is not guaranteed? What if your I.O.U. note comes not from the government, but from your cousin Bob, say, or from a volatile stock market-linked investment?
Without the certain guarantee that you’ll eventually be paid the full amount, the future value of the same sum of money is even lower because uncertainty as well as time value makes it less attractive.
A discount rate is therefore used to calculate the present value of the future uncertain payment. This discount rate reflects both time value and risk.
Time value of money and your investments
Time value is used in calculations to work out things like the present value of a growing annuity. These are built into financial calculators and spreadsheets; if you’re keen you can find worked examples on the time value of money Wikipedia page.
The rule-of-thumb is that money put away for longer periods of time will need to offer a higher rate of return to compensate you for it not being available to invest in other (potentially superior) assets during that time.
Uncertainty about the future also plays a part, as we’ve just discussed.
In a savings account you’d be worried about inflation. Would you be wise to lock away your money for five years at 5% if inflation was 4% and rising? Probably not.
With a fixed duration security such as a U.S. treasury or a UK gilt, the nearer the present date is to the redemption date when the government will redeem the issue, the likelier the issue will be priced close to its redemption value. Several years out, time value and uncertainty about factors such as inflation and national spending will influence the price, taking it above and below its redemption value.
The maths can get complicated, but the takeaway message is clear: For all assets, time, uncertainty and expectations together combine to influence the risk/return profile of that asset.
Time value of money is perhaps the most often neglected factor by private investors, but you need to consider them all when deciding whether a particular asset and/or the income it produces is a good investment.
Filed under: Financial glossary
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