August 23, 2019

How to explain Time Value of Money to your Clients?

Hemant Agarwal

Founder, Rupaiyaah

How to explain Time Value of Money to your Clients?

Time is money. That’s why the value of money is determined by the all-powerful TIME. When we talk about The Time Value of Money the most important aspect is the TIME.

Whether inflation determines the time value of money or its the other way round is a million-dollar question, that can be determined the day we know who came first – the chicken or the egg.

To put this idea across to our clients, we need to:

1. Understand the concept well ourselves
2. Be a good story-teller so that the client absorbs the concept without losing interest(pun intended!)

Let’s discuss a simple way of understanding and explaining this concept:

Girish’s phone rang and the sweet shrill voice from the other side introduced herself –  “Good Evening Mr. Girish. I am Pratibha calling from Maa Lakshmi Lottery. Congratulations! You have won a lottery of Rs 10,000. You can either claim the whole amount today or take Rs 13,000 after 3 years.”

Mr. Girish, like most of us, could not believe his luck. He did not want to waste any time. He never made decisions so quickly,  Yet, not wanting to let go of the opportunity of having the money in his hand today, he asked –  “Where should I come to collect my Rs. 10,000?”

Then, Girish called his financial consultant friend, Priyanka, to reconfirm the rationality of this decision.

Priyanka very diligently explained the concept and the calculation:

If Girish claimed this amount today itself and invested this Rs. 10,000 @7%(the prevailing Fixed Deposit Rate), Girish would be richer by Rs. 700 (7% of Rs. 10,000 for one year= 700) after a year. So his investment would be valued at Rs 10,700 at the end of the first year. (Please Note – taxation is ignored for ease of calculation).

This entire amount, when invested for another year will yield Rs 749 (7% of Rs. 10,700 for one year = 749), taking his total value to Rs 11,449(Rs. 10,700 from the first year plus the second year’s interest of Rs. 749)

Investing this accumulated amount for the third year will generate Rs 801 ( 7% of Rs. 11,449 for one year= 801)

So, the Future Value of Rs 10,000 after 3 years would have been Rs 12,250 ( 10,000 + 700 + 749 + 801 = 12,250 ) for Girish.

Girish could recall his mathematics classes. He wished he had just slowed down while taking the decision. Instant gratification, disregard, and non-understanding of the power of time and compounding resulted in a loss of Rs 750 ( 13,000 – 12,250 = 750 ) for Girish.

Economic Times reported on 6 March 2017 that Rs 1 Lakh of 1984 was worth Rs 7451 in 2016. We graduated from our desire of HMT or new found love for Titan in 1984 to brands like Panerai today. This duration of 32 years was enough for the Termite(inflation) to eat away your and my currency to this extent.

Priyanka went on to explain the impact of inflation on his future goals. Junior Girish, Girish’s 11 years old son, wants to pursue an MBA from IIM Ahmedabad 9 years from now. The cost of Post Graduation today is Rs 20 Lakhs. Rs 20 Lakhs kept by Girish in his locker will not suffice in the year 2028. Assuming the cost of education increasing by 5% every year, the same course will cause a total damage of Rs 3,102,656 ( 2,000,000 X [ 1 + 5% ] ^ 9 ) after 9 years. The Cost of our Future Goals is like water beads. The beads(read the cost today) absorb water (read the number of years) to grow bigger. 

The locker money will have devalued in this tenure. To keep up with the pace, Girish needs to find an avenue of investment that will be at par with the money-eating Termite i.e. inflation. If Rs 20 Lakhs is invested @5% it will precisely take care of the aspirations of Junior Girish.(ignoring all tax implications for ease of calculation).

A better option would be to invest in an instrument that will generate more returns than what is getting depleted by Inflation. So, if he gets 8% return he can invest Rs 1,552,101 ( 3,102,656 ÷ {[ 1 + 8% ] ^ 9 }) today instead of Rs. 20 Lakhs to ensure Junior Girish gets to enter the Mecca of Education.

William Shakespeare said, “Money is a good soldier, and will on.” This soldier will work for us only when we understand the role Time plays in determining the purchasing power of the Rupee and turn the tide to our benefit and adjust our sails according to the direction of the wind. We will find enough songs like the one from Johnny Kemp “Thank God it’s Friday night and I just-just-just-just-juuuuuuust got paid,” to persuade us to loosen our purse strings and let some currencies fall off for the party. That is when we understand how aligned are we towards our goals. We will shelve out only the amount allocated for our unwinding and fun when we have followed Dave Ramsey’s Budgeting principle of “Give every dollar a name”.