Time Value Of Money
In this section, we will study the concept of ‘Time Value of Money,’ which is an essential component of financial planning.
Suppose, You have won ₹10 lakhs in a lottery, and suppose you were given two options to redeem the money you’ve won.
1. Would you take the ₹10 lakhs as a lump sum in one shot immediately? Or
2. Would you prefer to receive it in equal yearly installments of 1 lakh over the next 10 years?
If you are like most people, you will have taken the money immediately. This is the right decision.
This is because of the concept of the Time Value of Money (TVM) which works on the power of compounding.
FV = PV x (1+R)^ n
FV: Future Value
PV: Present Value
R: rate of return
N: Number of time periods for which the money is invested
As per the concept of Time Value of Money,
Money that is available today is worth more than the same amount of money available at a later date, because you can invest it and earn a return / interest on it.
So, for example, if you had ₹10 lakhs available today, and you invested it into a 1 year Bank Fixed Deposit offering 7.50% in compounding mode, then in 1 year your money would be worth ₹10.77 lakhs.
The money you save and invest is the Present Value in your equation. R is the available market rate of interest and this factor is usually not in our control. Available investments offer certain approximate rates of return, and what you can do is choose your investment instrument carefully. The only factor in your control is your N, the time horizon. You can increase your investing time horizon by investing early on. The earlier you start investing, the higher will be your N, and the greater will be your money’s Future Value.
Let us consider an example to understand the concept better.
There are two friends – Anirban and Soumen.
Anirban started investing at the age of 20. Every year he invests ₹1000 into an equity mutual fund. He stops investing after 20 years.
Soumen started investing at the age of 30. Every year he invests ₹3,000 into an equity mutual fund. He also stops investing after 20 years.
Assuming they both earn the same rate of return on their investment (i.e. 15% p.a.), who do you think will accumulate more wealth by their age of 60?
The answer is Anirban. His investment of 1,000 per year for 20 years grows to ₹16.76 lakhs by the age of 60. Soumen’s investment of ₹3,000 per year for 20 years grows to ₹12.43 lakhs by the age of 60. Therefore, by beginning early, Anirban has given his investment the gift of time.
Increasing your time horizon is the best thing you can do to amass more wealth.
This brings us to the Power of Compounding – something Einstein referred to as the Eighth Wonder of The World – with good reason. You know now that the higher interest you can earn and the longer time horizon you can invest for, the larger will be your Future Value of money.
Let us take up another example to understand this.
Assume that you invest ₹1,00,000. When you will compare different instruments at different rates of return (R) across different time horizon (N), you might find results like these-
The above table indicates that for the longer N, equity is a better investment than a fixed income instrument. It is not prudent to let your wealth lie in a low-return instrument when your investment horizon is long. Also, over small time periods, the difference due to higher rates of return is not very huge.It is over longer time periods that the impact is very significant.
We will discuss more on the concept of Power of Compounding in the next unit.