How time eats up your money!

Compounding – the principle that underpins almost every savings and investment strategy throughout the globe. What exactly is compounding and how does it affect value of your money?

Q: A $10 note would still be $10 in 10 years from now. Value is still the same??

A: NO – over 10 years the value of your $10 note has gone down.

Q: Wait, my $10 note is as good as a new $10 note so how come its value

(TVM -2)

In the last article we tried to understand how compounding impacts returns on your money and therefore why money available today is more valuable than getting the same amount tomorrow (Time Value in Money, TVM). As you understand TVM now, we can move on to understanding its implications on your everyday money decisions.

The most important part of your money life where TVM can help you most is ‘maintain & increase the value of your money’. Most of you can understand what is ‘increasing value of money’ as we have already talked about that in the previous article. But do you know, what does ‘maintaining value of money’ mean?.

is lower??

Confused!!! Let’s try to understand with an example.

Mr. X is retiring in December 2019. He wants to understand if he can keep all his retirement money in a safe at home and live comfortably. His financial advisor say he should invest the money as value of money would go down with time. Mr. X can’t understand him, so his advisor tries to explain to him with an example of changes in price of a basic necessity like salt.

There are two factors that impact salt prices –

1. time (years) and

2. inflation (the annual rises in price)

The advisor goes ahead and shows Mr. X how his salt buying power would go down by 40% over next 20 years.

If Mr. X decides to keep his money at home, his progressive capacity to buy groceries would keep on going down. Just to maintain his buying power Mr. X needs to invest his money where it can grow atleast @ 2.5% (average inflation rate) for next 20 years.

Mr. X accepts his advisor’s suggestion and puts his money in staggered withdrawal investments to give him monthly income and grow rest of the savings @ 2.5%. How would his buying power graph look like now?

As a result, at end of 20 years also Mr. X is able to buy 1kg salt with the same $1 he invested @ 2.5% today. Hence, value of his $1 is maintained.

As you can see that even to retain the buying capacity of your money, it needs to atleast earn equal to price rise. The expenses are growing every year due to inflation and hence money too needs to grow. This is the most important aspect of money that you need to understand in order to not suffer shocks during your retirement period or other times of need in future.

Also, extrapolating this a bit further you would be able to understand why it isn’t wise to just stop at growing your money at a rate equal to inflation. Your money can do better for you by growing a rate higher than inflation and hence reducing the current investments required. This can make our current life easy while providing assurance for a comfortable retirement.

Now that you understand both inflation and TVM, next step would be to comprehend the magnitude of impact of inflation on your personal financial goals (now don’t say I don’t have any – every life goal has a financial part 😊). Hopefully, you can also see how compounding can help you maintain and increase value of your money. This brings us to our next topic, ‘Why start investing as early as possible?”. Let’s try to understand why start early with investing money in next article!

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