As promised, the following is an article on the importance of discounting, what it is and how it is relevant to your savings and investments.

What is discounting?

If I was to offer you £100 today or £100 in one months time, which would you rather have?

Well the answer appears obvious. - £100 today please! But why?

£100 today is worth more to you than £100 in one months time  This is because you can invest your £100 today or put it into a savings account and so it will be worth more than £100 in one months time. Furthermore, the effects of inflation erode the value of that £100 over time, so the money is definitely worth less in the future.

Why is discounting relevant to your savings and investments?

The significance of discounting to your investments means that every £1 invested today is worth more than every £1 invested in the future. This also means that your investment returns are not as impressive as you may automatically think, since inflation erodes the value of that £1 over time.

As a result, when making investment decisions based on future returns of your savings and investments you need to factor in discounting, 

An illustrative example of discounting:

Let us assume you have invested £1,000 in a company that pays a very nice 5% dividend paid annually. You may naturally assume that in one year your investment will be worth £1,050 ignoring all transaction costs and taxes and assuming This is simply 1.05 X £1,000. After another year your investment will be £1,102.5. That is calculated as such: 1.05 X £1,050.

In reality your returns are less due to discounting and this fact should be taken into account when making investment and saving decisions. I believe that returns should be discounted in one of two ways:

1) The opportunity cost method

The logic here is straightforward. If you were not going to put your money into a particular investment, where else is a safe way to store your wealth? It seems clear to me that a safe place to store your wealth would be in a bank account (aside from the previous financial crisis - but that's another debate!).

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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