A common practice for new parents is to set aside a sum of cash for their children at birth with the idea of putting this amount towards their first car, school fees, or even first overseas trip. You may have heard of this being done a few ways such as cash under a mattress, filling up piggy banks, or opening a savings account with your bank paying a special interest rate if left untouched. While all good strategies in practice, we’ve outlined a few important things to consider that could impact the amount you end up with, and how to maximise it!
Time value of money
The Time Value of Money (TVM) is a concept taught in many finance101 courses around the world. The TVM concept explains how a dollar in your hand today is worth more than the value of that same dollar in one years time. Seasoned investors know this, which is why they prefer to receive money today and put it to work immediately via saving or investing, rather than receive the same amount of money in the future.
Now if your head is spinning while reading this, then don’t worry. We’ve outlined below in simple terms the two ideas making the Time Value of Money concept work:
Earning potential – a sum of money will only grow over time if you invest it. If you do not invest it, you will have lost an opportunity to either earn passive income (via dividends) from that sum or have it experience capital growth (purchase a share for $10, it increases to $25, you’ve made $15 capital growth).
Inflation – generally a concept that a currency’s purchasing power declines over time due to the rising cost of goods and services, meaning that the relative value of your dollar is constantly being eroded. In other words, what $1 can buy you today will buy less of that same thing tomorrow.
To help illustrate these ideas further let’s consider two very basic scenarios facing new parents:
- Saving $1,000 for your child today in a bank account paying 2.5% interest
- Putting aside $1,000 in cash under your mattress
Money deposited into a savings account will have the capacity to earn interest over time. If you keep the interest earned in the same account, thus adding to the original principal, interest will then be earned on that interest. Earning interest on interest is a phenomenon known as compounding interest.
If left untouched, a savings account paying 2.5% interest every year will grow to $1,485 by the time your child turns 16, which is a $485 gain over the original $1,000 in cash.
A few points about inflation and opportunity cost
Understandably, new investors are torn between two frame of minds; positive investment returns can be very rewarding, but it is also reassuring knowing your funds are secure in a bank account.
However, you should take note of the interest rate being paid on your savings, and especially if it is high enough to outpace the expected inflation. In our example we didn’t account for the effect of inflation, but consider this; $1000 in cash might be able to buy
Another consideration is the opportunity cost of leaving your $1,000 in a bank account over that period. The opportunity cost is the inability to take advantage of other, potentially higher return, investment options because you have decided to tie your savings up in a bank.
How itrust invest Can Help
The bottom line is you don’t have to be at the mercy of inflation and opportunity cost.
It might be worthwhile to have a look at alternatives to saving accounts and the rates of interest they pay.
The philosophy behind the experienced funds management team at itrust invest is to make available its expertise to parents and guardians who are looking to provide a head start on their child’s financial future.
Let itrust invest help you by taking away stress from the decision-making process. We achieve that through our quality investment options, which provide opportunities for you to realise financial returns greater than savings accounts for your loved ones over the medium to long term.
Become a Guardian with itrust invest today and start to make a real difference to the future of your loved ones.
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