The Time Value of Money

The time value of money (TVM) is a fundamental concept in investing that states money available today is worth more than the same amount in the future due to its earning potential. This principle is driven by factors like inflation, opportunity cost, and compounding returns.

Why It Matters for Investors:

Investment Growth – Money invested today can generate returns through interest, dividends, or capital appreciation.
Inflation Impact – Over time, inflation erodes purchasing power, making future money less valuable.
Compounding Benefits – The earlier money is invested, the more time it has to compound and grow exponentially.
Risk Considerations – Delaying investments can mean missing out on potential gains or taking on unnecessary risk later in an effort to catch up.

For example, if you invest $10,000 at an annual expected growth rate of 5%, compounded yearly for 10 years, the future value would be:

     [FV = 10,000 times (1.05)^{10} = 16,288.95]

Where FV is future value and ^10 is the ten year holding period. For comparison, an investor could look at another stock that has a different expected growth rate and perform the same calculation. After taking the risks of owning each of these stocks into consideration, the investor can make a rational decision about which one to choose.

This principle is crucial when evaluating investment opportunities, discounting future cash flows, and making decisions about asset allocation.

For investors, the time value of money is a fundamental building block of every decision they make. Either the idea being considered is attractive in terms of the time value of money invested, or it isn't. The investor may not consciously frame it like that, but it's what drives their decisions nonetheless.