Time Value of Money – And Your Investments
At some time in your investing life, you’ve probably come across the term “Time Value of Money”. The usual example used to illustrate the concept it this – if you had a choice between receiving Rs. 1 lakh today, and Rs. 1 lakh after a year, which would you choose? Surely, you’d opt for the former. Logically speaking, this is because Rs. 1 lakh receive today can be invested at a bare minimum fixed-income rate of return of 7%, and grow to roughly Rs. 1.07 lakh in a years’ time. In other words, Rs. 1 lakh received today is worth the equivalent of Rs. 1.07 lakh received after one year.
The reverse applies too. Inflation will persistently gnaw away at the value of your money over the years, and so the time value of money that doesn’t grow at a sufficient clip, will actually reduce.
Indeed, as simplistic as the concept may sound - a clear understanding and awareness of the Time Value of Money can make you a much better investor. There are, however, some interesting nuances that come into play when it comes to this investing concept.
Cognitive Dissonance
Investors tend to display a high degree of cognitive dissonance when it comes to Time Value of Money – the phenomenon wherein one’s actions are at odds with their beliefs. For instance, you may be well aware that the value of Rs. 50,000 per month when you retire 30 years later will be inconsequential in real terms – but yet choose to channelize your retirement savings into an asset class that promises you just that. Similarly, as a newly retired person who needs Rs. 1 lakh per month to sustain a comfortable lifestyle today, you may choose to ignore the effect of inflation (despite knowing CPI and WPI values by heart!) and purchase a fixed return annuity that provides you with a constant sum of money every month for the next 25 years.
Hyperbolic Discounting
As an investor, Hyperbolic Discounting is your biggest enemy. Essentially, this phenomenon makes us attach exponentially higher degrees of importance to money-goals that are close to today’s date, and exponentially lower degrees of importance to money-goals that lie in the distant horizon. To understand this better, let’s go back to the first example, but with a twist – if you had the choice between receiving Rs. 1 lakh today and Rs. 1.1 lakh after a month (both guaranteed), what would you opt for? Most likely, 1 lakh today – although from a Time Value of Money standpoint, it makes sense to wait for a month and receive an annualized return of 120%! This seemingly undiscerning act is the result of a behavioral phenomenon that leverages the compelling power of “now” and magnetizes you into action. In other words, Time Value of Money concepts go out of the window when a reward is staring you in the face.
Cost of Delay
When we explain the ‘cost of delaying’ savings to investors at forums, they usually recoil in shock. Some of them even disbelievingly ask to see the spreadsheets! For instance, the cost of delaying a Rs. 20,000 per month, 25-year retirement saving for 1 year is – hold your breath – a colossal Rs. 44 lakhs! The concept of “cost of delay” and “time value of money” are intricately linked, and the seemingly high delay cost actually arises because the delay cost compounds over the years. Simply put, by delaying
your saving of Rs. 20,000 per month (Rs. 2.4 lakhs per year), you rob your portfolio of the compounded growth that this Rs. 2.4 lakhs could have benefitted from over a 24-year investment horizon.
Whether you’re a first-time investor or a seasoned saver, a periodic visitation of the concept of Time Value of Money will certainly stand you in good stead with respect to your future goals.
