To understand the concept of time value of money, we first need to understand that time has a cost. If you keep your money idle under your pillow, then you are losing out on the interest or dividends that you could have earned by investing this money. In economics this is referred to as the opportunity cost of money. When you keep money idle, you are losing out on opportunities to earn returns, which is not what a rational person would do. Since time has a cost, you need to be compensated and that comes in the form of interest payable.
In the above chart, we have plotted how various asset classes compensate for time value of money over a period of 10 years. We have also adjusted for tax and dividend yield implications. For example, bank FDs are taxed at your peak tax rate and hence the effective return after tax is very unattractive. Equities have returned nearly 12.7% after considering the dividend yield. The moral of the story is that if you are looking at compensation for time value over a longer time frame, then equities is the answer.
Time value has important implications when you are planning for your long term goals. Remember, the longer you stay invested in quality assets, the greater your chances of creating wealth. Here is a case study of how Rajesh gets the better of Nayan by playing the Time Value Game more smartly. Rajesh starts investing in an equity mutual fund SIP in 2015. He allocates Rs.15,000 per month to an Equity MF SIP which is yields 16% returns annually. Nayan, on the other hand, starts later and in 2020 begins an Equity MF SIP of Rs. 30,000. The end result is quite interesting
The above table clearly demonstrates that Nayan has his understanding of time value entirely wrong. By starting early, Rajesh has the power of time value on his side. Rajesh has seen his wealth grow to Rs.44.47 lakhs while Nayan’s wealth has grown to Rs.27.67 lakhs. In fact, for Nayan to reach the same wealth level as Rajesh by 2025 he will have to invest Rs.48,250 each month! The difference arises due to the power of compounding (which is another name for the Time Value of Money). Since Rajesh has a 5 years head start, he had already created a corpus of Rs.13.84 lakhs by the time Nayan had started his SIP. Time value has clearly worked in favour of Rajesh and against Nayan.
The relationship between time value and wealth creation is dependent on the following three things. First, you need to start investing early. Second, get exposure to higher return assets such as equities. Third, consistently stick to your SIP plan with discipline no matter the disruptions and shocks in the market. By consistently following these steps you can unlock the benefits of the time value of money to create wealth for all your life’s goals.