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Time Value Of Money

07/10/00 02:51:27 PM
by Han Kim

How much money do you really have? Over time inflation will decrease the value of your investment and your profit may not be as large as anticipated.

Security:   N/A
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One factor that is not often taken into consideration when calculating rates of return is inflation. This means that a dollar today is worth less than a dollar in the future. Let's assume that the inflation is 3% annually (3% is the average inflation rate for the last 10 years). Supose you invested $100,000 ten years ago and the value of your investment grew to $125,000. Thinking that you made a profit of $25,000, you redeem your investment. In reality, at a 3% inflation rate, your $100,000 needs to be $134,392 to have the same purchasing power as you did with $100,000 ten years ago. Therefore your 25% gain is actually a loss of $9,392.

The breakeven point is calculated using the following formula:

Future Worth = Present Worth * (1 + Inflation rate) ^ Number of years
F = P(1 + i)N

We'll use the $100,000 investment we've been discussing as an example:

Future Worth = $100,000 * (1 + 0.03) ^ 10
Future Worth = $134,392

If your investment will return greater than this breakeven point, you will have beat inflation and actually made a profit. However, if your investments will not return as much, then you should consider an alternative investment.

The chart below displays the equivalent future dollars to equal today's $100,000 over a 30-year period.

.
Graphic provided by: Microsoft Excel.
 
As you watch your investments grow, you can factor in inflation and get a more realistic idea of your profits.



Han Kim

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