The value of a dollar changes dramatically, depending on when you can take control of the dollar and invest it. The critical variable in the exact value of a dollar is time. If someone owes you a dollar, do you want him to pay you today or next year? Yes! The answer is, Today. With inflation consistently destroying the purchasing power of a dollar, a year from now a dollar will be worth slightly less than it is today. “Inflation” is an economic term used to describe the gradual tendency of prices to rise over time. If inflation is 2% per year, which means that prices, on average, will rise 2% over the next year, which in turn means that your dollar can purchase 2 cents less in a year than it can today. That’s right, with 2% inflation, a dollar today is worth only 98 cents in a year. However, if you got the dollar back today, you could invest it. If you invested it in say the stock market or mutual funds, and your investment returned 10% over the course of the year (which is somewhat less than what the market average has historically returned), then you’d have 1.10 USD at the end of the year. So your money would be growing instead of shrinking, and you’d be guarding yourself against the negative effects of inflation. So the net or real, adjusted for inflation value of the dollar would be 1.08 USD (10% return on our investment less 2% inflation).
Time value of money principle also applies when comparing the worth of money to be received in future and the worth of money to be received in further future. The tipping point of time value of money is that a dollar in hand today is more valuable than a dollar in hand in future, because you could invest that dollar today and earn interest and thus multiply your financial assets or use it to your requirements. The time value of money is related to another concept called opportunity cost. The cost of any decision includes the cost of the best forgone opportunity. If you pay 10 USD for a movie ticket, your cost of attending the movie is not just the ticket price, but also the time and cost of what else you might have enjoyed doing instead of the movie. Applying this concept to the 100 USD owed to you, you see that getting the money in installments will saddle you with opportunity cost. By taking the money over time, you lose the interest on your investment or any other use for the initial 100 USD, such as spending it on something you would have enjoyed more.
The more you invest today, the more you’ll have in the future. In fact, if you leave this dollar invested, its value will mushroom over time through the miracle of compounding. Compounding is so miraculous that even at relatively low returns you can double and triple your money over long periods of time. If you doubled your money in 10 years with an annual return of 8.3% and the market benchmark gave a return of 11.2% then you have underperformed the market. Hence the aim is not to double the money but to outperform the market. As you earn investment returns, your returns begin to fetch you returns as well, allowing you to turn a measly dollar into thousands of dollars if you leave it invested long enough. Real wealth, the stuff of dreams, is in fact created almost magically through the most mundane and commonplace principles: saving, patience, time, and the power of compounding.