Let’s imagine for a second that someone offers you $100. No obligations, no strings, no fine print. You just stick out your hand and they give you $100 of cash.
Then, let’s imagine that a second person comes to you with a ‘better’ offer—one hundred and five dollars. But there’s a catch: you’re going to have to wait a year before you see your money.
Which option would you choose?
Most of us would choose the first option. After all, a year is a long time to wait, and if you have $100 today, you can invest it today and possibly make more than the extra $5.
Welcome to the time value of money
All of this is a long way of explaining the time value of money. Put simply, this is the idea that a dollar today is worth more than the same dollar tomorrow. The sooner you get a dollar, the more that dollar is worth to you. Time is literally money.
This makes intuitive sense, but let’s have a look at exactly why this is the case:
If you put $100 in the bank, you’ll be able to get a 2% interest rate. So at the end of the year, your $100 will have turned into $102. Great! All you have to do is not spend the money in the meantime.
This can help to give an idea of how much more valuable a dollar is today than it is tomorrow. If someone offers to borrow $100 from you, and give you $100 back in a year’s time, you’re better off financially declining their offer and putting the money in the bank, where you’ll get $2 in exchange for waiting.
These amounts look pretty small, of course, but once you get into larger amounts, they start to add up—especially when you consider the other factors like compounding interest!
Time Value of Money also connects with inflation. Money is really just a way to get the things you want. Problem is, the things you want tend to rise in price over time. This means that a dollar is less valuable in the future than it is now, because all the things you buy with that dollar will be more expensive. For example, if you spent $100 on some stuff in the year 2010, you’d need to spend $113 to get the same stuff today.
This means that $100 from 2010 would actually be worth less than $100 now, because it would buy you less stuff! You’ve gone backwards!
So when you’re thinking about the time value of money, you need to think about the fact that the things you will want to buy will be more expensive in the future. This means that $1 in the future is less valuable than $1 today.
Finally, another important concept is opportunity cost. That’s the stuff you could have spent money on today, if you had it.
Let’s say you want to invest in ETFs through Sharesies. The one you have your eye on is $1 per share, and you want to buy 10 shares. But you have a problem—you’re fresh out of money, and you’re going to need to wait a couple days until payday.
Once payday rolls around, the ETF has gone up in price, to $1.50 a share. Those 10 shares that would have cost you $10 are now going to cost you $15. Rats! If you’d been paid earlier, you would have saved $5 on your investment.
Wrapping it all up
Does this mean you should only invest in the short term? No way! We are all about long-term investing. But make sure you’re thinking about the time value of money. A good rule of thumb is that the longer your timeframe, the higher your returns should be. Because while a dollar today beats a dollar tomorrow, two dollars tomorrow probably beats a dollar today!