The Time Value of Money

Question: Would you rather have $1.00 today, or $1.15 a year from now? Economists have been asking this question of their students and study volunteers for decades. The overwhelming answer is to take the $1.00 today. But is this the smartest choice?

If you wait a year, you will get $1.15. That works out to a 15% return on your delayed gratification decision. 15% is pretty good, no? So why do most people opt for the $1.00 now?

Part of it has to do with the innate human tendency to want everything now, not later. Part is due to a mistrust of the system. How do I know if the $1.15 will really be there a year from now?

But the main culprit is a lack of understanding of the time value of money. A 15% return is very favorable by most standards, especially when it's guaranteed as it is in our experiment. You may not care about what happens to $1.00, but what if your entire life savings were on the line?

Would you really turn down a guaranteed return of 15%, without having to do any work to earn it? Most investors say no, they wouldn't turn that down. They instinctively know that a 15% return is better than no return at all, and they gladly accept the offer.

For investors, the time value of money is a fundamental building block of every decision they make. Either the idea being considered is attractive in terms of the time value of money invested, or it isn't. The investor may not frame it like that, but it's what drives her decisions nonetheless.