One of the foundational principles of finance is the time value of money (TVM). This sets forth the concept that a dollar held in the present has more value than a dollar held in the future. The reason for this is twofold: first, money currently held may be invested for higher financial return. Second, inflation will impact the current dollar's value and reduce its value if it is not spent or invested in the present.
TVM relates closely to the concept of purchasing power, or how much a product or service costs. One readily identifiable example is the cost of gasoline: for many US consumers, 20 years ago $50 would have filled up a vehicle tank, while two decades on it might fill up half a tank or less. Similarly, the box of cereal that cost $4 on supermarket shelves 10 years ago might cost, on average, double that today.
Purchasing power is eroded by inflation. When investing, a critical threshold is that the rate of investment return should exceed the rate of inflation. As an example, if one earns eight percent interest each year, but inflation is headed upward at a 12 percent rate, four percent is lost in purchasing power each year. The TVM principle thus leads to investing in items, whether real estate or stocks, that exceed the inflation curve.
It’s important to note that the TVM concept does not hold true 100 percent of the time. Time value of money leaves out scenarios of capital losses or negative interest and growth rates, in which money held intact can actually gain value.
TVM relates closely to the concept of purchasing power, or how much a product or service costs. One readily identifiable example is the cost of gasoline: for many US consumers, 20 years ago $50 would have filled up a vehicle tank, while two decades on it might fill up half a tank or less. Similarly, the box of cereal that cost $4 on supermarket shelves 10 years ago might cost, on average, double that today.
Purchasing power is eroded by inflation. When investing, a critical threshold is that the rate of investment return should exceed the rate of inflation. As an example, if one earns eight percent interest each year, but inflation is headed upward at a 12 percent rate, four percent is lost in purchasing power each year. The TVM principle thus leads to investing in items, whether real estate or stocks, that exceed the inflation curve.
It’s important to note that the TVM concept does not hold true 100 percent of the time. Time value of money leaves out scenarios of capital losses or negative interest and growth rates, in which money held intact can actually gain value.