Time Value of Money — Most Important Concept in Financial Planning

Editor’s Note: In a recent podcast, CIEL’s Uma Shashikant suggests that ‘Time Value of Money’ is the only concept that average person needs to know in personal finance. Deepesh Raghaw attempts to explain this concept to our readers in this article.

What would you prefer? Receive Rs 100 today or receive Rs 100 after 1 year. Clearly, you would prefer to receive Rs 100 today. Why? There are two ways to look to explain the answer.

The money (currency) loses its value over a period of time. The phenomenon is commonly known as inflation. Therefore, Rs 100 today is worth more than Rs 100 after 12 months. To give an example, with Rs 100, you may be able to purchase 50 pencils today. However, it is possible that you can purchase only 48 pencils after 12 months. In this case, as you can see, the same amount of money can buy you less after a year. Assuming everything else is constant, inflation has reduced the purchasing power of money.

The other way to explain your answer is that you could have invested Rs 100 in a fixed deposit today and at the end of the year, you could have had Rs 106 (say) due to interest income on the fixed deposit. Obviously, it is better to have Rs 106 instead of Rs 100.

The above concept that money in hand today is worth more than the same amount on a future date (because it can earn returns) is referred to as Time Value of Money.

You could have heard stories from your grandparents or great grandparents about how they could purchase an entire month’s grocery for Rs 40 or 50. That amount does not fetch you anything today. That is time value of money for you. 1 kg rice is still 1 kg rice. Just that the value of rupee has gone down due to inflation. To put it another way, the value of Rs 40 or Rs 50 in those days is same as value of Rs 10,000-Rs 15,000 today.

Time Value of Money and Your Investments

This concept has great value when it comes to investments or how you think about investments. When you invest, you are essentially foregoing consumption today. Now, you know that your money will lose value due to inflation over a period of time. Therefore, your expectation should be such that your investments grow at a pace equal to or faster than your money is losing value. Considering the earlier example, if I can buy 50 pencils today, I should be able buy at least 50 pencils after a few years with my investment value. And that is a fair expectation. If this was not true, you would have been better off spending that money than investing it.

Many of us prefer to keep our investments in fixed deposits. However, most of the time, the post-tax return on fixed deposit is unlikely to beat inflation over the long term. This means you are effectively losing out. Your money will be worth less when it matures. By the way, I am not saying you must not invest in fixed deposits. A bank fixed deposit is a very good product. All I am saying is that you must be aware of its inability to beat inflation. Therefore, a fixed deposit may not be a good investment choice for the long term. While investing for the long term, you must consider some exposure to growth assets such as equities. Such investments are likely to beat inflation over the long term and preserve your purchasing power.

Caveat. You cannot earn better returns without taking additional risk. Therefore, even though growth assets such as equities may give you potential of better returns, such assets come with considerably higher risk than bank fixed deposits. And risk can materialize. Therefore, when you invest, the only motive can’t be just to earn inflation-beating returns. The motive should also be to earn returns that are commensurate with the risk you are taking.

How Should You Look at Your Investment Returns?

Time Value of Money also offers an insight into how you should assess your returns from an investment.

Common story. My father purchased a plot in 1980 for Rs 1 lac. Now, its value is Rs 50 lacs. Essentially, the value has gone up 50 times. Great investment!!! However, how much of the return is due to rupee losing its value over last 37 years and how much of it is due to investor’s smart decision making? If the rate of inflation was 8% p.a., the value of Rs 1 lac in 1980 is same as Rs 17 lacs today. Only the return in excess of Rs 17 lacs is due to your intelligent decision making. Assuming the present value of investment was only Rs 15 lacs (and not Rs 50 lacs), it is not really a very good investment (even though the value has gone up 15 times). In fact, even the Government does not tax you on the gains due to inflation. For instance, long term capital gains on sale of property/gold/bonds/debt funds is 20% after accounting for indexation.

Long Term Capital Gain = Sale Price – Indexed cost of purchase

Tax liability = 20% * Long Term Capital Gains

The Government releases cost of inflation index that you can use to calculate your indexed cost of purchase.  

How Do You Plan Your Retirement?

I have seen people do simple calculations to plan for their retirement.

“My current expenses are Rs 25,000 per month. That makes it Rs 3 lacs per annum (Rs 25,000 X 12). I expect to live for another 30 years. Therefore, I need Rs 90 lacs (Rs 3 lacs X 30 years) by the time I retire.”

The biggest issue with this approach is that Rs 25,000 per month may be enough today. However, it may not be enough after 30 years (assuming you are 25 years old today). Why? Because inflation would have eaten into the value of your investment. At 8% inflation, Rs 25,000 after 30 years is same as Rs 2,484 today. Alternatively, if you need Rs 25,000 per month now to meet your expenses, you will need Rs 2.51 lacs per month after 30 years. If you had planned to save only Rs 90 lacs, you will run out of money within 3 years of your retirement. To put it another way, you need Rs 90 lacs in present value (and not Rs 90 lacs in future value) for your retirement. During retirement, inflation can be your biggest enemy. You need to preserve the value of your money by making the right investments.

How You Can Be Tricked?

Financial services companies tinker around with the timing of cash flows to give you an impression of higher returns. Happens regularly with traditional life insurance plans. Typically, in such plans, bonus is announced every year. However, the bonus is paid only at the time of maturity. Till maturity, the bonus amount simply accrues and does not earn any return.

Let’s say policy matures in 20 years. The insurance company announces a bonus of Rs 40,000 for your policy in the first year. However, you will not get Rs 40,000 after the first year. You will get this amount without interest after 20 years. If, at the time of purchase, you thought you would get Rs 40,000 every year, you got it completely wrong. If you got Rs 40,000 every year, you could have invested the amount and ended up more than Rs 40,000 at the end of 20 years.

I have discussed this aspect in great detail in another post. The insurance companies realize the time value of money and insurance agents smartly build their sales arguments around these bonuses. If you do not pay attention  to the timing of cash flows, you may be in for a negative surprise later. Unfortunately, we cannot do such complex calculations in our minds. We need spreadsheets to assess the impact of timing of these cash flows.

Conclusion

Time Value of Money is perhaps the foremost concept when it comes to financial planning. If you can’t appreciate the damage inflation can inflict on purchasing power of your assets, it is difficult to plan your finances well. Always remember that money in hand today is more valuable than the same amount of money a year later. You can invest today, earn return and end up with a higher amount. Alternatively, the purchasing power of money goes down due to inflation, i.e., you can buy more today with same amount than you can after a few years. In my opinion, those who understand this concept can make it work to their advantage and make prudent investment choices. Those who don’t understand it will be taken advantage of by unscrupulous salesmen and fail to have enough savings for retirement.