Understanding time value of money

source: videoblocks.com

The time value of money refers to the fact that a cedi today is worth more than the promise of a cedi in the future. Some reasons for this include the common human desire for immediate gratification and the increased risk of non-payment when the expectation of cash is deferred over a period of time. Even if the person who owes you money is scrupulously honest, there is always a chance that he could run into problems and be unable to pay you back. Besides, if the money is in your pocket, you can do whatever you want with it. This is why lenders charge interest on money borrowed, and why investors expect some kind of financial return on their investments. So at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later.

The time value of money is a fundamental concept in finance and it influences every financial decision you make, whether you know it or not. It is fundamental to money management and is key to understanding stocks, bonds, financing your loans, and making good business investments.

We all know the time value of money intuitively: GH¢1000 now is better than GH¢1000 one year from now. Thus the value of any given amount today is not the same tomorrow. One major factor which influences the value of money is inflation. Inflation they say is the destroyer of money. It actually reduces the purchasing power of money.

Suppose you buy a 1 year bond for face value that pays 10% at the end of the year. We pay GHS100 at the beginning of the year and get GHS110 at the end of the year. Thus the bond pays an interest rate of 10%. This 10% is the nominal interest rate, as we have not accounted for inflation. Whenever people speak of the interest rate they’re talking about the nominal interest rate, unless they state otherwise.

Suppose inflation rate is 7%, we can buy a basket of goods today and it will cost GHS100, or we can buy that basket next year and it will cost GHS107. If we buy the bond with a 10% nominal interest rate for GHS100, sell it after a year and get GHS110, buy a basket of goods for GHS107, we will have made 3% gain on the investment.  So after factoring in inflation, our GHS100 bond will make a real gain of GHS 3.00 instead of GHS 7; a real interest rate of 3%. Thus at the end of the period, you actually made 3%. The value of your money has reduced due to high inflation. Nominal rate 10%, real rate 3% (10%-7%=3%)

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As an investor, you must look at your real rate of return. Unfortunately, investors often look only at the nominal return and forget about their purchasing power altogether.

Every investor must learn to protect his investment against inflation so as to maintain the value of his money. In times of inflation when money becomes less valuable, shrinking in power, the investor must position his wealth in a way that he can sleep soundly.

There are no fixed methods but there are some things you can consider with a good financial planner done correctly, they have the potential to significantly reduce your risk from inflation shocks.

Steps to maintain the Value of money

#1: Avoid a High Concentration of Long-Term Bonds in Your Portfolio

When it comes to worrying about the inflation rate, bonds are the single most vulnerable asset class. In fact, inflation can destroy the net worth of a bond investor just like moths eating and destroying clothing. Often, by the time you notice, it is too late. This happens because most bonds receive a fixed coupon rate that doesn’t increase. If you buy a 30-year bond that pays a 4% interest rate, but inflation skyrockets to 12%, you are in serious trouble. With each passing year, you are losing more and more purchasing power regardless of how safe you think investing in bonds is.

#2: Own Investments That Can Increase Cash Flows

If costs increase, a manufacturing company can increase the prices they charge for a product. If costs increase, an insurance company can charge more in premiums. If costs increase, an apartment building owner can increase rents in most areas of the country. These are examples of businesses or real estate that have some built-in protection from a rise in the inflation rate. If the investments you own have pricing power, you can survive bouts of high inflation without getting hurt too badly.

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#3: Own Commodities That Move Independently from Currencies

If you own a farm that produces commodities such as wheat or corn, oil fields that pump out crude, gold, silver or copper mines, or other assets that trade like commodities, you probably aren’t going to need to worry about inflation as much as you otherwise would have. If people need oil, or wheat, or gold, they will pay for it in whatever currency you will accept, even if we are back in the Stone Age, trading sea shells and feathers.



The bottom line is that you don’t have to suffer from a high rate of inflation. There are steps you can take to reposition your investment portfolio to safeguard against a loss in purchasing power. So the next time you think of investing, consider the rate of inflation. You will be protecting the future value of your wealth and maintaining the purchasing power of your money.






Omega Capital Limited is an Investment management, private equity and   investment advisory firm. The Company is authorized and regulated by the Securities and Exchange Commission of Ghana.

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Additional information is available upon request. Information has been obtained from sources believed to be reliable but Omega Capital Limited                           (“Omega Capital” or “The Firm”) do not warrant its completeness, accuracy or veracity. The firm is licensed and regulated by the Securities and Exchange Commission of Ghana (SEC). This material is for information purposes only and it is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and estimates herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information.

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