Friday, October 14, 2011

Time Value of Money

Ever hear the phrase that time is money?  I thought I'd make a post for the general public who might not know much about such a topic while we learn everything about it in business school.  In this sense, there is an actual price associated with the value of money over time.  If given the choice between $1 today and $1 in a year, nobody would ever pick the latter. Intuitively, getting a $1 today and keeping it until a year from now will be the same as the latter choice, except that you have the option to spend it on something within a year if you find an opportunity.  From a financial perspective, you could also put the $1 into a bank account today and accumulate interest for a year, receiving more than $1 in a year.

As you might infer, this means that holding cash over a long period of time means bad news for the value of your assets.  If you don't invest your dollar or put it into a bank account, the value of keeping it for a year goes away and you will be left, essentially, with the second option in our hypothetical choice above.  I'm not suggesting that you never carry cash, but if you have an extra $100 that you won't be using for a while, there are better places to store it instead of your wallet.

Another thing that hasn't even been considered yet is inflation.  What is inflation?  Inflation is the decreasing value of a single dollar during periods of time when the supply of money is high.  It can also be thought of as the general increase in price level of goods and services over time.  Almost everyone should be familiar with the recent rise in gas prices at the pump.  A dollar 20 years ago would have bought a lot more gas than a dollar today can buy.  Generally, inflation occurs as economies grow and the specifics as to what causes inflation would take much longer than a single post to teach.  However, what you do need to know is that inflation is one of the main reasons why your dollar decreases in value.

So where should your money go to stay safe and retain its value (or perhaps even increase its value)?  I've shown how stocks usually are the safest way to keep and grow value over the long run, but for shorter time periods, it may be better to look at bonds or savings accounts.  Given the current economic climate and the low yields on bonds and savings accounts, there may be little cost to holding your money as cash.

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