What is Time Value of Money? And Why it is expremely important in Investing?
Time Value of Money
Time value of money implies that money paid or received in the future are different from the money paid or received today.
This is one of the most important concepts in finance. It implies that money paid or received in the future are different from the money paid or received today.
It is easier to understand that ₹1000 in your wallet today is worth more than ₹1000 in your wallet 5 years in the future.
This is because you can invest that ₹1000 in your savings account and earn interest for 5 years and get more than ₹1000 5 years later.
This is why investing and investing in right asset is important. An investment delayed is an opportunity lost.
Investors prefer to receive money today rather than the same amount of money in the future because if you receive the money today, you can invest it and grow it further.
For example, money deposited into a savings account earns interest. Over time, the interest is added to the principal, earning more interest. That’s the power of compounding interest.
If it is not invested, the value of the money erodes over time. You will lose the additional money it could have earned over that time if invested. It will have even less buying power when you retrieve it because inflation has reduced its value.
Here is a simple example, say you have the option of receiving 1,00,000 now or 1,00,000 3 years from now. Despite the amount being equal, 1,00,000 today has more value than it will 3 years from now due to the opportunity costs associated with the delay. In other words, a payment delayed is an opportunity missed.
This is where opportunity cost comes into picture.
What Is Opportunity Cost?
In investing terms, Opportunity costs represent the potential benefits an investor misses out on when they choose one asset over another.
Because opportunity costs are unseen, they can be easily overlooked. So we need to consider opportunity cost for better decision-making.
If you take real life example, consider you have 2 job offers, 1 job offers high pay with low job security, whereas other job offers low pay with high job security.
Which one would you choose?
Regardless of which one you choose, you would be losing out on some of the benefits offered by the other job. That’s opportunity cost.
If you take a financial example, say you are buying a house at the start of the career by getting a loan of 50L at 6.7% for 20 years. You will have to pay 38K rupees as EMI for next 20 years for this loan.
At the end of 20 years, you will have a own house which would probably worth somewhere between 30L to 1Crore.
Instead, if you have invested this 38K rupees in MF for 20 years, and assuming that MF generates 12% annualized returns over this time period, then your investment would have grown to 3.76 Crores.
So this difference of at least 2.75 Crores is your opportunity cost of buying that house. Seems like a huge cost, isn’t it?
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