Taking the nosebleed out of personal finance
Time value of money basically says that money you have today is more valuable than if you were to have the same amount of money in the future
I am having a hard time absorbing all of those personal finance lessons, especially those that have to do with math. Can you help me understand them better?
—Posted on PFA’s “ask a friend, ask Efren” service at www.personalfinance.ph
Answer: Personal finance covers a broad range of topics. For this article, let’s just focus on time value of money, current income and capital appreciation.
Please choose one: Option A—I will give you P1,000 now; or Option B—I will give the same P1,000 to you one year from now. No doubt, you will choose Option A. Why? There can be immediate gratification if you receive the money now as you can already watch a movie with a friend with it and perhaps buy a snack or two.
On the other hand, I would have to give you an incentive for waiting one year to receive spending money. This incentive can come in the form of giving you slightly more than P1,000 so that your wait will be rewarded with the ability to bring two friends to watch a movie and buy more snacks.
In addition, even if you stuck to bringing one friend to the movies and buying a snack or two, doing so one year later may be more expensive because of inflation (i.e. the general rise in prices of movie tickets and snacks).
Time value of money or TVM basically says that money you have today is more valuable than if you were to have the same amount of money in the future. And this is why people need to invest their money; so that they can be rewarded with the ability to enjoy more things in the future by deferring their spending and also so that they can keep up with the rise in prices brought on by inflation.
Interest or yield is the reward that is given to lenders and investors. Just imagine, a lender is sacrificing enjoying his money now to lend to someone in the hope of enjoying more in the future and beating the inflation rate as well. Whether the interest rate is justifiably high or not is not the subject of this article (at least not for now).
Investors are looking for the same reward when they place their funds in stocks, bonds and real estate. But the reward comes in two potential types, current income and capital gains. In other words, investors can potentially earn periodic income, and a windfall should they sell their investment at some point in time (i.e. in the case of bonds, the sale should come before the maturity date of the bond).
It is easy enough to see that bonds will have periodic income from the interest that they pay. But what about stocks?
Companies that earn more than they need to reinvest for continuous growth will pay out cash dividends. In fact, if a company cannot make a decent return on money that it intends to retain, it is better off paying out that money as dividends. Many stable companies are regular payers of cash dividends because their businesses have become more predictable given their enormous momentum for generating earnings. So at least for the stable or blue chip companies, periodic income can come in the form of regular cash dividend payouts.
What about real estate? Well, property can be rented out. The rent is the periodic income.
Investors can also make a windfall if they sell their bonds in a period of declining interest rates, cash in their stocks when prices are on an upswing and flip their property when prices are booming.
As an aside, our discussions point to the fact that raising capital from equity investors is not free. Equity investors do expect rewards, either in the form of periodic cash dividends or significant capital gains.
Please note that I earlier mentioned potential rewards. A bond issuer can default on its interest payments while rising interest rates make bond prices go down. A company may fall on hard times and opt not to pay out cash dividends because of lower net income, which at the same time has the effect of lowering that company’s stock price. A tenant can miss out on rental payments while a glut in the supply of property may soften property prices.
That is why it is also very important to consider risk together with reward. But please understand that risk is not the reward. In fact, it is the very presence of risk that enhances investment returns; call it the spice of investing.
If you want more nosebleed-free personal finance tips, please visit www.personalfinance.ph. You may also attend our EnRich™ personal finance and EnRich™ estate planning training runs in Cagayan de Oro, Iloilo, Davao, Cebu, Clark and Manila. Details for EnRich™ training runs may be found on the website.
Efren Ll. Cruz is a Registered Financial Planner of RFP Philippines. He is best selling book author of Pwede Na! (A Complete Guide to Personal Finance) in 2004, and is the chairman and president of the Personal Finance Advisers Philippines Corporation.
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