What is discounting?
Why is discounting relevant to your savings and investments?
An illustrative example of discounting:
1) The opportunity cost method
The average savings account is currently paying about 1.75% per annum. This means that for every £1 invested you are missing out on the opportunity of keeping your money relatively safe and earning a 1.75% return. As such, for every predicted £1 made on your investment, we need to scale it by the opportunity cost of gaining the risk free rate of 1.75%.
In the case of the above illustrative example, after the first year we would have made £1,032. This is worked out by dividing the cumulative gains after the first year (£1,050) by the risk free rate (1.75%), i.e £1,050/1.0175. The £1032, is the true value of your investment after one year.
2) The inflation method
Similar to the first method this scales your investment by inflation so as to give it it's true value adjusted for inflation. Since inflation is about 2.4% at the moment that would mean a calculation as such £1,050/1.024 resulting in a return discounted at the rate of inflation at £1,025. Check out a previous article for a clearer understanding of why inflation should matter to you in terms of investing. Essentially, inflation erodes the real value of your wealth over time. This discounting method takes account of that fact to produce the real value of your investment.
Other Possibilities for discounting
There is much debate over what percentage investments should be discounted at. I have provide reasons for two possibilities above. Let me know if you have any other suggestions.
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