Time Value of Money
Why a dollar today is worth more than a dollar tomorrow
If someone offered you $10,000 today or $10,000 in ten years — which would you take? The answer seems obvious. But why is today's money worth more? Two reasons: it can grow through compounding, and inflation erodes its purchasing power over time.
The time value of money is the foundation of all finance. Every investment decision, every valuation model, every interest rate — they all rest on this single idea: money available now is worth more than the same amount in the future.
Understanding this concept is the first step to thinking about returns, risk, and what “growth” actually means after inflation.
The two forces
Compounding (grows wealth over time)
FV = PV × (1 + r)n — Future Value equals the Present Value multiplied by (1 + annual rate) raised to the power of n years. Each year, returns accrue not just on the original investment, but on all the accumulated returns from previous years. Small differences in rate compound dramatically over time.
Example: $10,000 at 7% for 10 years = $10,000 × 1.0710 = $19,672
Inflation (erodes purchasing power)
Real Value = Nominal ÷ (1 + i)n— the nominal balance divided by (1 + inflation rate) raised to the power of n years. Even if the account balance grows, rising prices mean each dollar buys less. The “real” return is what matters for purchasing power.
Example: $19,672 nominal after 10 years at 3% inflation = $19,672 ÷ 1.0310 = $14,635 in today's purchasing power
The real rate of return combines both forces using the Fisher equation: (1 + nominal) ÷ (1 + inflation) − 1. A 7% nominal return with 3% inflation gives roughly a 3.9% real return — not 4%.
Educational content only — not investment advice, recommendations, or a suggestion to act. Past performance is not indicative of future results. Your decisions are your own. Full disclaimer.
See it in action
Adjust the sliders to see how compounding and inflation interact over time. The gap between the two lines is what inflation takes away.
Adjust parameters
Nominal Value
$38.7K
Real Value
$21.4K
Real Return
3.9%/yr
What to notice:
- The gap widens over time — inflation's effect compounds just like returns do
- Try 7% return with 3% inflation vs 4% return with 0% inflation — similar real outcomes, very different nominal numbers
- Extend to 30-40 years — see how even small rate differences create enormous gaps
- Set inflation above the return rate — watch real purchasing power decline even as the account balance grows
Your turn
Consider how this concept applies to savings and investment decisions in general. When someone says their portfolio returned 8% this year — was that before or after inflation? What was their real return?
Most financial headlines quote nominal returns. The real return — what your money can actually buy — is always lower. This gap is small in low-inflation environments but can be dramatic when inflation rises.
Reflect in your JournalWhat you've learned
- -A dollar today is worth more than a dollar tomorrow — because it can compound and because inflation erodes purchasing power.
- -Compounding works exponentially: FV = PV × (1+r)ⁿ. Small rate differences create enormous gaps over decades.
- -The real return = (1 + nominal) ÷ (1 + inflation) − 1. A 7% return with 3% inflation gives ~3.9% real growth, not 4%.
- -Thinking in real terms matters. A growing account balance means less if prices are growing faster.
Want to test this?
Many experienced investors suggest practicing with a paper money account on a reputable broker before risking real capital. Many brokers offer free simulated trading environments where you can test strategies with real market data and no financial risk.
Paper trading lets you build confidence, understand execution, and see how a strategy behaves in real time — without the emotional weight of real money on the line.
Important
Everything on this platform is educational and didactic in nature. We do not provide investment advice, financial advisory, or recommendations to buy or sell any financial instrument. Past performance is not indicative of future results. All strategies shown are historical simulations for learning purposes only. Always do your own research and consult a qualified financial advisor before making investment decisions.
Educational content · Not investment advice or recommendations
We're educators, not advisors. Your decisions are your own. Disclaimer