LOUISE FAIRSAVE: Time value of money
ANOTHER POWERFUL ASPECT of learning to spend wisely is being aware of the alternatives. We can spend, save or invest our money. Getting a better understanding of the time value of money best guides our decision-making among these alternatives. How can time be our very best friend?
Famous 18th century American statesman, Benjamin Franklin, is credited with the adage “time is money”. This simple expression draws attention to the fact that a $100 today is worth more a year later. In absolute terms once that sum is invested and earns interest or a return, it will be worth more at the end of the year. Yet that gain in value all depends on the prevailing inflation rate. If the inflation rate is higher than the interest or return earned by investing the $100, then it would actually be worth less in purchasing power at the end of the year.
It is important to be aware of the inflation rate in deciding how and where to invest savings. Where the inflation rate is high or expected to rise superlatively, for example where there is significant currency devaluation, it would make more sense to spend the money buying needed valuables that will tend to retain their relative value.
Then, although time presents the opportunity to increase the sum held, when the choice of investing the sum fails or loses value, the sum will lose commensurate value over time. For example, investing in a small business, buying shares in a company or purchasing bonds and securities could result in investment losses if the related business undertaking should fail or have a significant financial setback.
Another way of recognising that “time is money” is noticing that every job or service takes time and payment is often based on the time spent. Usually, the more time spent, the larger the sum of money earned.
Time is our best friend though mainly through the application of compound interest. The effect of compound interest can make time and money work together to magnify the growth in value of money set aside more and more as time passes.
For example, if you were to save $100 per month and invest it in a fund at the end of each year for 25 years, earning five per cent interest per annum compounded, instead of having the $30 000 that you would have put into the fund, the fund would be worth $46 206 after that 25-year period.
If you were to just leave the accumulated fund invested at the same rate and never add another penny to it, at the end of another 40 years, it would be worth a remarkable $325 292. The passage of time, a long time, would have converted your modest saving into a grand sum.
The earlier one starts on a saving and investing programme, the better will be the outcome. Time is one’s best ally; it allows your money to work for you in the interim. The higher the interest rate that you can earn on your investment fund, the quicker it will balloon to a grand sum.
For example, if it was possible to earn an interest rate of eight per cent per annum compounded over the periods involved, the fund would have grown to over a million dollars – $1 445 726. In this age of uncertainty with regard to the availability of adequate pensions in years to come, is such an investment not worth considering?
The converse is also true: the later you start to save and invest, and the lower the interest rate earned, the more difficult it will be to accumulate a substantial fund. From 2016 onwards, do make time and compound interest your best friends.
• Louise Fairsave is a personal financial management adviser, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances. This column is sponsored by the Barbados Workers’ Union Co-op Credit Union Ltd.