DISCOUNT RATE DYNAMICS (FOR THE UNINITIATED).

As we go along on our adventure, it is important that all adventurers share a basic understanding of some fundamental finance concepts. The most fundamental of these concepts is the "discount rate."

The discount rate is used to project what money will be worth at a later date in time, the so called time value of money.

By way of illustration, imagine that you had an apple in your hand. That apple would be worth the most to you fresh and ripe. IF you were to let the apple linger for a few days before eating, it would perhaps become a somewhat mealy as the fruit lost its crispness, and the sugars changed. That apple might still be good for a less valuable purpose: as apple sauce perhaps, but it could never again be worth as much as a new fresh apple.

So it is with money. The penny candy of yesteryear could not be purchased today without spending perhaps a whole dollar. Meaning in real terms that the penny of yesteryear required to buy a piece of penny candy, ain't worth a dime today.

This concept is most often used in reverse. (In REVERSE?) Money to be paid in the future is typically "discounted" back to today's dollars. (Decisions are simpler when all factors are known. Attempting to value down an investment to the future would require greater knowledge.)

So if you have a choice between a hundred dollars today, and 1,000 in 20 years, you can understand which to take based on the value that the future 1000 dollars would have, if you were to have it in today's money. Going back to the apples, you would have to understand the value of 1000 fetid, 20 year old apples in today's terms. If it doesn't sound like a great deal, remember that the discount rate applied to apples is probably higher than the discount rate applied to money.

As a word of warning: while the discount rate, seemingly, is the rate of inflation. we need to remember that because money is a finite resource, an investment in one thing, precludes an investment in another.

And it's easy to compare data... If you look at the rate of growth for the S&P 500, and the rate of inflation, it's clear that investment in the S&P has increased in value more rapidly than investment in money. Investment in apples, of course, led declines. That may not be the case forever. In fact, depending upon when you invested in the S&P 500, your investment could have actually DECLINED in value at a faster rate than inflation made money worth less... There is a risk involved in investment that has to be considered as we try and determine an appropriate discount rate. The answer is not simply "the S&P's average growth rate" or "the average rate of inflation."

More on that another time, however, as this post is long enough as it is.

I should include the basic formula for determining money's waste over time for completeness sake... Here. Is the Wikipedia entry on the subject.
Here. is the "Money Chimp" entry.

Here is the formula:

The Present Value of Money = The Future Value DIVIDED by One PLUS the interest rate, with that number raised to the amount of time to be measured (usually years)

PV = FV/(1+i)^Number of years