Financial Basics: Understanding the Time Value of Money

Canadians have trouble understanding a whole gambit of financial concepts like inflation, interest rates, credit reports, stocks, risk, debt and loans, according to the 2014 Canadian Financial Capability Survey*. In the most recent edition of survey, released November 26, 2019, there are emerging signs of financial stress for some Canadians, especially those who don’t have a budget or financial plan. This week, KBR starts a new series on financial basics to help.

In the spotlight is an interesting book, The One Financial Habit That Can Change Your Life, authors Robert Ironside & Edwin Au Yeung, who make one very simple case: Make the time value of money work for you, not against you. Here’s an excerpt from this primer on investment fundamentals.

MAKE THE TIME VALUE OF MONEY WORK FOR YOU, NOT AGAINST YOU.

So there you have it. . .the One Financial Habit That Can Change Your Life!  If you do this—make the time value of money work for you, not against you, in every financial transaction you contemplate - you’ll win.

Here’s what we mean: 

Let’s start by playing a game. Suppose I offer you a choice between $1,000 today and $1,100 one week from today. Would you prefer the instant gratification of having $1,000 today or would you prefer to wait and get an even larger amount in one week?

As long as you trusted me and trusted that I really would pay you the $1,100 in one week, most people would probably choose the $1,100 in one week’s time. After all, $100 is a lot of money to earn for waiting only one week.

Now, let’s continue the game. This time, I’ll reduce the amount next week to only $1,050. Now what would you choose? Is $50 enough to induce you to wait one extra week to win your prize?

We could continue playing the game, reducing the amount available next week, until everybody has decided that they would sooner have the $1,000 today instead of waiting a week for a slightly larger amount.

Does this make sense? If it does, then you have just understood the essence of the time value of money. 

Can it really be this simple? Of course, the answer is both yes and no. The basic concept of the time value of money is simple but the devil is always in the details.  A good understanding of the time value of money and its applications can help us sort out truth from fiction and even help keep us out of the reach of financial predators like Bernie Madoff and many, many others like him, who promise us untold riches without any risk.  But we will get started in understanding a concept that can and will irrevocably change our lives and futures for the better.

The Financial Concept to Remember:

In its simplest terms, the time value of money tells us that a dollar received today is worth more than a dollar received tomorrow.

A dollar in our hand today is worth more than a dollar to be received tomorrow. In some ways, this simple truth seems self-evident, but why must it be true?  It must be true because, if we have the dollar today, we can invest it and earn interest, so that when tomorrow arrives, we will have more than one dollar of wealth.

How much more wealth we will have in the future depends on three things:

• How much money we have to invest today
• The length of time we are investing our money
• The interest rate or yield that we can earn on our invested funds

If we want to know the increase in the real purchasing power of our new wealth, we have to include one more factor: the rate of inflation, which is usually discussed in the press as the rate of change in the consumer price index or CPI. For the sake of simplicity, we are going to ignore inflation in this chapter. Ignoring inflation is not a big problem when inflation rates are low, like they have been lately, but it will be a problem if and when inflation returns in the future.

So far, this probably sounds about as exciting as watching paint dry, but perhaps some examples will change your perspective.

Why get excited about the time value of money?

The time value of money can change your life, but you must understand how to make it work for you, not against you. This simple truth is something that the wealthy have known for many generations. But, given how few people understand it, it must have been a closely guarded secret. Well, guess what – now you too have the opportunity to learn what the wealthy have known for a long time. 

The Financial Concept to Remember:

Time Matters.

When you are young, time is your friend, and it delivers big-time. Life is an exciting journey that has just begun. This is especially true when it comes to your money. Every year that you wait to start saving is a year that you can never recover. Even waiting a few years until you can “afford” to save some money will dramatically increase the amount that you have to save each year to achieve the same retirement wealth.

Why is this true?  What is this magical power that allows money to grow to such large quantities?  It is called compounding, and it is the magic that makes the time value of money so powerful.  In fact, Albert Einstein called compound interest the most powerful force in the universe!

Compounding refers to the reinvestment of interest, so that it begins to earn more interest. What happens when interest is not allowed to compound?  In this case, it is called simple interest and the results are startlingly different. 

You now know about the time value of money and the most powerful force in the universe – compound interest.  So become a saver, not a borrower.  Otherwise, the time value of money works for them, not you!

Order this book online here.

*2014 Canadian Financial Capability Survey

Additional Educational Resources:  Financial advisors are encouraged to check out Knowledge Bureau’s certificate courses, Debt and Cash Flow Management, or Tax Strategies for Investors to help clients with life-changing financial habits like this!

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