What does the Time Value of Money mean?
The time value of money is the value of an amount of money factoring in an amount of interest earned over a given period of time, and is one of the key concepts in finance theory.
What the concept allows you to do is place a value today on a likely stream of income in the future.
This is very useful when trying to determine the value of a company or of a proposed project, as you can project cash flows into the future and ‘discount’ them back to today’s value using an appropriate rate of return.
A bird in the hand…
Cash received in the future is worth less than cash received today.
Due to inflation, opportunity cost (what you might be doing with that cash in the meantime) and also a risk that you never receive the cash for an unforeseen reason – what happens far into the future is inherently more uncertain than what happens right now.
Back in the days when people spoke in sage proverbs rather than in financial jargon, they said: “a bird in the hand is worth two in the bush”.
Property investors usually know this intuitively. If a depreciation schedule offers you two methods of claiming deductions – diminishing value or prime cost – which do you choose?
Well, it depends on personal circumstances, but usually the answer is the one that gives you the biggest deduction now, because who knows what may happen five or ten years from now?
Applying the time value of money to investment
The clear implication of the time value of money concept is that it is crucial to invest in assets which outperform the rate of inflation.
The financial press announced this year that the “best performing” asset class over the past decade was global bonds (being developed world and emerging market bonds).[sam id=40 codes=’true’]
I have a few problems with this. One is that there is no such thing as a free lunch in investing so greater returns from bonds tend to be sourced from an increased risk of volatility and default.
Secondly, what chance does the average investor have of accurately analysing the risk/return profile and ongoing likelihood of default on individual global bonds? I’ll answer that one for you: Buckley’s chance.
Now sure, a diversified portfolio or fund of global bonds can be a very useful addition to a portfolio as it can act as a deflation hedge and is likely to act in a non-correlated manner to your equities and your home or investment real estate.
But bonds shouldn’t be your portfolio. Over time what you need are ownership assets (rather than lending assets) and assets that grow for you.
Who were the real winners of the past 10 years?
If you invested $100,000 a decade ago in term deposits you would of course have had a comfortable and worry-free ride. But the price you paid for your certainty of cash-flow was a lack of growth – you simply get your $100,000 capital back today.
With a couple of blips, inflation has largely been under control over the past decade thanks to the Reserve Bank’s targeted range of 2-3%, but your money is still worth significantly less than it was in 2002.
What about if you had put your $100,000 in shares? Well, things were going swimmingly from 2002 to nearly 2008, weren’t they?
But some unscrupulous individuals in the US had gone a little bit loco lending money to people who unfortunately had no jobs or assets to pay the money back, and they managed to short circuit the financial system, freezing the credit markets in the process and crucifying prevailing stock market valuations.
Nevertheless, had you diligently re-invested your dividends you have still done reasonably well over the 10 year period. You might well have doubled your capital to $200,000.
The biggest winners, though, were those who owned property, because of the leverage that is commonly employed in that asset class.
OK, you know the theory, but what does this mean in practice? Let’s go back to Residex
’s numbers for the last month.
Suppose you invested your $100,000 in a $500,000 house in Melbourne, which surprisingly, was the second worst performing capital city over the past decade after Sydney.
You used an interest only loan
to invest in any average home and achieved the average annual return of 6.4% capital growth.
Your mind isn’t playing tricks.
Excluding any holding costs even by investing in an average house in the second worst performing city you would have increased your $100,000 into more than half a million dollars of pre-tax equity.
Growth would not have occurred in such a linear fashion, instead property markets move in ebbs and flows, but those who have owned property for the long haul have quite literally, remained streets ahead.
In my opinion, the next decade is unlikely to provide average capital growth that is as high as the Residex numbers above.
There is a simple solution to that: don’t be average!