Simple Guidelines to Understanding the Time Value of Money, Relative to Your Long-Term Savings

When it comes to the principles of time & money, relative to your long-term savings, three important components immediately come to mind:

1. Time value of Money – TVM
2. Compounding interest
3. Inflation

“Why does this matter to me?” is usually the first question we hear when we talk about the concept of Time & Money, and the second most common statements are “I will do it later.” or “I cannot afford it right now.”

We sincerely hope that, by the time you have read this short article, we will have answered the above questions and you will fully understand the simple benefit of starting to save as early as possible, working towards your future investment/retirement needs and maximising your potential returns.

TVM

TVM is the idea that money available at the present time is worth more than the same amount in the future, due to its potential earning capacity. This is a core principle of finance which holds that provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also referred to as ‘present discounted value’.

Compounding interest

“Compound interest is the eighth wonder of the world. He who understands it earns it … he who doesn’t … pays it.”
-Albert Einstein.

Compounding is the process where the value of an investment increase because of the earnings on an investment, both capital gains and interest, earn interest as time passes. This exponential growth occurs because the total growth of an investment along with its principal earns money in the next period. This differs from simple interest, where only the principal earns interest each period.

This phenomenon, which is a direct realisation of the time value of money, is also known as compound interest.

Example: suppose a R1,000 investment in Company A earns 20% in the first year. The total investment is then worth R1,200.

Next, assume that in the second year, the investment earns another 20%. In year two, the total balance of R1,200 would earn 20%, ending with a value of R1,440 instead of R1,400. The extra R40 of growth is due to the R200 earning of year one also growing at 20% in year two, along with the principal.

Inflation

What exactly is inflation? In simple terms, it is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of money is decreasing in time.

When it comes to Money and inflation, you must understand, as time passes, with Inflation the value of your money will fall as general prices rise, and you will be able to buy less with the value of Money you had in the past.

Now that you understand these three core components, when it comes to the value of time and money, we can use two examples (over-leaf) when it comes to investing.

Examples

Both investors will invest the same amount toward retirement at 65, with the same yearly increase on their monthly contributions. The only difference is that investor one, will start at the age of 25, and investor two will start at the age of 35.

Final Conclusions:

• By starting early, Investor 1 was able to better take advantage of compound interest.
• Investor 1 contributed approximately 33% more than Investor 2 over time, but ended up with more than triple in future value.
• With this example, you will also be able to see the effect of Inflation on the value of your money and the importance of inflation beating returns (Real Returns).

The above examples show that starting to invest earlier has greater benefits and make compound interest work in your favour.

Jacques L Marais

Client Portfolio Manager