The Effect of Time on Money
Investors frequently look upon money as a constant.
However, it only takes a little consideration to realize that money itself is a variable.
The most useful way to view money is in terms of its purchasing power.
How much money do you need to buy a pair of leather shoes or a flight to London or a week’s supply of food?
Although you may be lucky enough to see the sum of money in your trading account or bank account increase in a time period, its purchasing power may decrease.
This is the phenomenon of inflation.
In an inflationary environment, it makes sense to spend your money today, because if you hold on to it for a day/week/month/year it will lose its purchasing power and you will be able to buy less stuff when you spend it. In a deflationary environment, the opposite holds true:
don’t spend your money today because soon enough its purchasing power will increase and you’ll be able to buy more stuff with it in the future than you can now.
The effect that time has on money is often overlooked by investors.
The ultimate aim of any investor is the allocate funds in such a way that the future purchasing power of his or her investments grows with time.
It’s possible that while the absolute value of your investments can grow, their purchasing power decreases.
This can be so even when you make an apparently respectable return in a financial environment in which inflation appears to below.
For example, in the period starting 1998 and ending 2006, the S&P500 index rose approximately 27 per cent.
Over the same period, inflation ran at 26 per cent.
(Of course, we are talking here about inflation over a nine-year timeframe, not annual inflation which ran somewhere between 1.6 per cent to 3.4 per cent during this time.)
So you could argue that by investing in the S&P500, your capital held its purchasing power.
If however, your intention was to use your capital to buy a home, then the bad news was that during that time the average price of a home in the USA rose by approximately 100 per cent. Inflation-adjusted house prices for the United States.
The message here is that when you invest, you need to know why you’re investing.
The effect of time on purchasing power has different consequences in different sectors.
If you were investing to buy a house, then it is probably better to buy an investment whose value will track house prices rather than hoping that an investment in stocks will track (or beat) house prices.
There are a number of equations you can use to calculate the effect of time on money. The main consideration involved is choosing the correct annuity formula.
Scenarios that can be calculated using an annuity formula are, for example:
• the effect of inflation on saving the same sum of money regularly at a known interest rate
• how much money you need to save each year at a know interest rate to accumulate a target amount of money
• how quickly a mortgage at a known interest rate can be paid off with regular payments
• how quickly your money will run out if it is invested at a fixed interest rate and you are spending a fixed amount each year, which is greater than the interest you are receiving
To invest successfully, it’s vital you know the reason your investing and how time can influence the purchasing power of your money.
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