Loading ...The Time Value of Money and the Miracle of Compounding
The time value of money is a potent concept for producing security and wealth. It’s the central economic concept behind such investing principles as interest, compounding, dollar-cost-averaging, and long-term investing. It’s the concept that says that a dollar in your possession today is worth more than a dollar you will receive tomorrow.
Because the time value of money is the cornerstone of all financial planning, we need to establish a thorough understanding of this powerful concept if we’re to attain financial security throughout life.
Is a dollar always worth a dollar? No. Sometimes a dollar is only worth 80 cents, and sometimes it’s worth $1.20.
Why? The value of a dollar changes dramatically depending upon when you have possession and control of the dollar (the right to invest it).
The critical variable in the exact value of a dollar is time. Money must grow in time to be worth the same amount as it is today. Money left on its own is devalued by inflation.
If someone owes you a dollar, do you want him to pay you today or next year? (Yes! Another trick question! The answer is, “Today.”)
With inflation consistently destroying the purchasing power of a dollar, a year from now a dollar will be worth slightly less than it is today.
“Inflation” is an economic term used to describe the gradual tendency of prices to rise over time. If inflation is 2% per year, that means that prices, on average, will rise 2% over the next year, which in turn means that your dollar can purchase 2 cents less in a year than it can today. That’s right, all you mathematicians out there - with 2% inflation, a dollar today is worth only 98 cents in a year.
However, if you got the dollar back today, you could invest it. If you invested it (along with a few of its cousins, we hope) and your investment returned 10% over the course of the year then you’d have $1.10 at the end of the year. So your money would be growing instead of shrinking, and you’d be warding off the damaging consequences of inflation.
In fact, if you leave this dollar invested, its value will mushroom over time through the miracle of compounding. As you earn investment returns, your returns begin to gain returns as well, allowing you to turn a measly dollar into thousands of dollars if you leave it invested long enough.
The more money you save and invest today, the more you’ll have in the future. Real wealth, the stuff of dreams, is in fact created almost magically through the most mundane and commonplace principles: patience, time, and the power of compounding. To heck with your lousy odds in the lottery or with someone’s “Wealth in Nanoseconds!” pitch
The time value of money is an integral concept in retirement planning. When a compound interest is applied to the concept we see that the money can earn interest on itself, including the money earned by the interest. A powerful combination.
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