3 Investment Principles Every Young Person Should Know: #1 Time Value of Money

by Cameron Schaefer on November 5, 2007

Since my last post I have had time to read more of Ramit Sethi’s, I Will Teach You To Be Rich blog. As I have read the articles and seen the demand for simple financial education…and after many discussions with friends it has become obvious to me that many college and twenty somethings have not been introduced to basic money and investment principles that most close to finance would consider fundamental. For the next few days I’ll be laying out the three investment principles every young person should know.

#1 – The Time Value of Money

Time Value of Money Graph

The basic premise of the time value of money is that all else being equal an investor is better off receiving a certain amount of money today than he is receiving that same amount of money in the future. Basically, money now is better than money tomorrow. To most people this is instinctive, of course you would want money NOW! But why? One would assume that the value of $1 today is equal to the value of $1 a year from now, but this assumption is wrong. The dollar received today is more valuable because of all the ways you can make it grow. Just by putting it in a savings account you’ll at least earn interest on it, thereby increasing its future value Here is an example:

You are given the choice between
Option A: $100,000 today
Option B: $100,000 in 3 years.

Lets say you decide to take Option A and invest your $100,000 in a savings account with a simple annual rate of 5%.

Future value of investment at end of first year:
= ($100,000 x 0.05) + $100,000
= $105,000

Next you leave this money untouched and let interest continue to accumulate

Future value of investment at end of second year:
= $100,500 x (1+0.05)
= $110,250

These equations rolled together would be equivalent to:

Future Value = $100,000 x (1+0.05) x (1+0.05) OR
$100,000 x (1+0.05)^2

Using this logic after three years the value of the $100,000 would be:
= $100,000 x (1+0.05)^3
= $115,762.50

This equation allows us to calculate multiple years or periods of interest without having to add each period up individually and is the basis for one of the most basic finance equations out there:

Future Value = Present Value x (1+interest rate)^number of periods

FV equation

NOW, before you zone out from too many numbers. Here is the bottom line. Option A, in this case, is $15,762.50 more valuable than Option B, who’s future value is equal to its present value. And remember, this is just assuming you put the money into a savings account making 5% interest. Option A could in fact be much more valuable if you instead invested the money in the stock market which has averaged approximately %10 percent return per year over the past several decades.

Compounding interest (another discussion in itself) allows our youth to work for us in mighty ways so that the money we have today is in fact much more valuable than money we will have in the future. Albert Einstein was quoted as saying, “The most powerful force in the universe is compound interest.” Understanding the time value of money principle allows us to harness this force and create wealth.

{ 9 comments… read them below or add one }

Dividends4Life January 28, 2008 at 11:28 am

Excellent post! Thanks for sharing it. I plan to include your article in my weekly carnival review this Friday.

Best Wishes,
D4L

Cameron Schaefer January 28, 2008 at 11:35 am

D4L,
Thanks so much for your interest and checking out Schaefer’s Blog. Please let me know if there are any other posts you’d like to use or if I can be of any help. Enjoyed your blog as well!

Lily January 28, 2008 at 3:38 pm

Blast from the past! (Specifically, my intro corporate finance course in college.)

Even without compounding interest, there’s a time value to money. $1 today is worth more than $1 tomorrow in a positive-inflation environment. $1 today is worth more than $1 tomorrow because you gain liquidity (although a more real-world example would be that a CD earns returns because you need to be compensated for the liquidity you give up). $1 today is worth more than $1 tomorrow because there’s always the chance that the person who promised you $1 tomorrow goes back on his or her word.

All of my professors pretty much hammered TVM into us. It’s so fundamental to how money works – you’re doing a great service by explaining the concept to the world! :)

Cameron Schaefer January 28, 2008 at 8:23 pm

Lily,
So glad to take you back to the college years, haha! Great points, thanks so much for your comment. I too had my professors hammer principles like this home during my finance classes. I hope you check out the other two principles and offer your thoughts. Checked out your blog as well, enjoyed the perspective of someone who’s in the middle of the action.

shah August 5, 2012 at 8:09 pm

Interest means u burying your money in a tomb
Better way is to invest your money instead of letting the bank invest your money and take all the profit and give you a slight share of 1% -2%
Remember by investment,trade or any other buisness you do..you can multiply your money without any barrier maybe *10 or * 20 times..and interest rates cant even double your money in an year or two or three!

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Sohan/easefinancebd April 3, 2015 at 2:38 am

Time Value of Money concept is not so difficult to understand at all. “One dollar at present worth more than one dollar in future”. The value of money changes with time. In fact, the value of money always decreases with time. So if you have $100 today and you keep it for next one year, surely you will have less value than today. $100 today worth more than $100 worth after one year. For more detail visit-
http://easefinancebd.blogspot.com/p/basic-finance.html

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