Time Value of Money and Inflation Risk
$100 Today is Worth More Than $100 Tomorrow
“Time value of money” is a term that simply states one dollar received today is worth more than one dollar received in the future. You may think “Isn’t it a dollar just a dollar?” Well yes, a dollar is in fact just a dollar, but the financial term “time value of money” (also referred to as TVM) reminds us of one basic, but fundamental fact: that dollar is earning interest all the time.
The longer a dollar is invested and earning interest, the more interest and money it accumulates. Below is a simple example of what could happen by investing just $100.
- Put $100 at the beginning of the year in a savings account that earns 1% interest per year, at the end of the year you will have $101 just by letting it sit there.
- The following year, your account may earn 1% on the amount it has at the beginning of the year ($101) and therefore, could finish the year with a total of $101 plus $1.01 (1% of $101) equaling $102.01.
- By letting your $100 just sit in the bank for two years, you could make $2.01. Even though the reward might be small, it is true that $100 today could be worth more than $100 tomorrow.
Now, what happens when instead of going to the bank, and depositing your $1 or your $100, you go home and stick it in your sock drawer or under the mattress? You are then exposed to what is called “inflation risk.” Inflation is simply defined as a general increase in prices. It is the risk of money not being able to buy as many goods or services because of a rise in prices.
- You put a $1 bill in your wallet when the price of your favorite power bar is 90 cents.
- You may be unaware of current economic conditions, but say the ingredients in that power bar become more expensive for the company that produces it due to inflation.
- Two months later, you go to the store to buy the same bar that was 90 cents before, now it’s $1.10 and you can’t afford it.
Remember, risk is not a certainty, but it is definitely something to be aware of
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