Time Value Of Money Can Affect Your Stock Market Journey. Here’s How

16 January 2024

The stock market is a great way to make money, but it can also be a dangerous place. As with any investment, there are risks involved. You need to know what these risks are and how to avoid them if you want to have a positive experience in the stock market. The good news is that you can minimize the risk of losing money by being prepared and making smart decisions before investing.

One way to do this is by understanding the time value of money (TVM). TVM is an economic theory that shows how future cash flows affect present values. It shows how interest rates affect the amount of money you will receive at different points in time.

To explain the concept of Time Value Of Money, it is a term that is used in finance to describe the concept of a penny today being worth more than a penny tomorrow. This idea is based on the fact that money has the potential for growth and investment, and as time goes on, investments have the potential to grow exponentially.

Calculation of Time Value of Money

In the stock market, this concept is important because it allows investors to get more value for their money by investing in stocks that have a higher expected return on investment, or ROI. The formula for determining the time value of money is:

PV= FV/(1+(i/n))^(n*T)

FV= Future Value

PV= Present value

i= interest rate

n= number of compounding periods per annum

T= number of years

Let’s consider an example:

Given the future value of Rs.10,000 payable 2 years hence, let’s compute the present value if the interest rate is 10 % per annum.

PV= 10000/(1+10%/1)^(1*2)= Rs 8264.5

Alternatively, one can compute the future value of money as well-

FV = PV*(1+(i/n))^(n*T)

FV= Future Value

PV= Present value

i= interest rate

n= number of compounding periods per annum

T= number of years

Let’s consider an example.

Assume one invests Rs 12000 for 2 years at Rs 8% p.a.

FV= 12000*(1+(8%/1)^(1*2)= Rs 13996.8

PV= Rs 12000

i= 8%

n=1

T=2

TVM brings out the compounding effect of money, whereby money has the capability to grow over time. In the above example, as against annual compounding, say the compounding was half-yearly, the FV would be still higher.

FV= 12000*(1+(8%/2)^(2*2)= Rs 14038.3

PV= Rs 12000

i= 8%

n=2

T=2

Thus, the future value depends upon or is directly proportional to the interest rate, the time period, and the compounding frequency.

The higher the interest rate, time period, and compounding frequency, the higher the future value. This is understandable as well. Say one invested in a financial instrument that provided interest income only once a year and invested in another instrument that provided interest income twice a year i.e. every 6 months.

Assuming the same rate of interest, the earnings would be higher in the latter case. The compounding frequency pertains to each year i.e. half-yearly, quarterly, monthly, or daily.

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Money indeed has a time value to it and the longer you wait to spend it, the more valuable it becomes. The concept of the time value of money can be used when making many investing decisions, including when and how much to invest in the stock market. Here are some reasons why it can bless your investments:

• You will be able to calculate how much a stock is worth based on its future value, which will help you calculate how much to pay for it.
• You can understand why some stocks are priced higher than others even though they both offer similar returns (the one with a higher return may offer less risk).
•  Time value of money helps you take advantage of compounding interest rates
• It helps you determine a fair price for an investment
• It lets you understand how much you will gain from a particular investment over time
• It helps you decide how much risk is appropriate for your portfolio

What if you do not Apply the Time Value of Money on your Investment Journey

A stock market is a volatile place, and it can be difficult to navigate. However, there are some things that you can do to help your chances of success. One of these is following the time value of money principle.

Here are a few disadvantages of not following this principle on your journey through the stock market:

1. You Can Not Optimize Your Investments

When you invest in stocks, you want to make sure that you’re getting the most benefit from your investments. This means investing in stocks that pay dividends or that pay out a lot of interest.

But if you don’t know how long it will take for those dividends or interest payments to grow into something substantial, then it’s hard to know whether or not an investment is worth making at all.

1. Missing Out on Opportunities Because They Seem Too Good to Be True

If someone tells you that they have found “the next big thing” or “the next big stock,” chances are that there’s something wrong with their reasoning and their plan for investing money in this company won’t go anywhere but down.

If you don’t know what kind of timeline there is for making money from an investment opportunity, then it could end up costing you more than just being taken for a ride by someone who knows nothing about what they are influencing someone.

1. You Won’t Be Able to Plan Your Life Goals/retirement as You Want

Not only will you be losing money, but if you don’t use the Time Value of Money principles on your stock market journey, it will take longer for you to reach financial independence and achieve the freedom that comes with being able to quit your job and live off of your investments.

If you’re not earning enough interest on your investments (and saving less than 20% of your income), it may be hard for you to retire early or save up enough money for other important life goals like buying a house or starting a family—all while having enough income during retirement.