The Background
I often wonder why people avoid financial planning and one of the points is the fear of numbers in many of us.
Unfortunately much of financial planning is based on mathematics. But fortunately the mathematics is not really complicated. You probably learned the basic principles in School.
It is practically all based on the idea that principal multiplied by interest rate over time equals interest earned. Interest = Principal × Interest Rate × Time. Also, Readers know about my personal finance equation, which was:
Income(t) – Expenses(t) = Savings(t) + Investments(t) where time t signifies moving money, or purchasing power, backward and forward in time. So let’s talk about the time value of money.
The Time Value of Money
Let me take a simplistic example to make my point. Imagine you have Rs 1,00,000 with you and you have the following options (inflation rate is 5%):
- Give it to a friend who will return Rs 1,00,000 after one year.
- Put it in a Savings account which gives you 5% annualized return.
- Invest in a Mutual Fund/Stock which can give you a return ranging from -50% to +50% (Isn’t it like trying to hit a sixer and getting caught on the boundary!!)
In option 1, The present value of the Rs 1 lakh that you get after one year is actually (1-5/100)(1,00,000) = Rs 95, 000. Do you realize that you have actually lost money? (Btw, I am not saying not to help a friend. Please do that whenever you have the chance, please. Friendship is bigger than a crore as your networth)
In option 2, the money grows by 5% to Rs 1,05,000 but once you factor the inflation (5%), you are back to the square one. Better to spend the money today rather than wait for one year.
In option 3 , your future value can be higher or lower than the present value.
These are very simple examples. And if you are hating me for stating the obvious, bear with me for a second.
The point I am trying to make here is that these are the basic principles of maths that you need to understand to manage your financial planning. And these concepts can help you with all your financial decisions like retirement planning, planning for your children,etc!
For example I know you may be having a lot more questions. They are:
1. How to find a Future Value using a Present Value over a period of Time and an Interest Rate when there are No Payments
2. How to find a Future Value using a Present Value over a period of Time and an Interest Rate when there are Payments
3. How to calculate the Payment required to Accumulate a Given Amount over a Given Time period
4. Calculation of Interest to Deplete a Given Amount, or Pay Off a Loan
5. Time required to Deplete a Given Amount, or Pay Off a Loan
6. Calculator for Evenly Spaced Payments of Equal Amounts
7. Calculator for Equally Spaced Payments of Unequal Amounts
8. etc, etc.
My point is that the basic principle applies to all these questions. And isn’t it simple?
Do get started on a spreadsheet and do some number cruching for yourself. The formulas are programmed into most financial calculators and several spreadsheet functions (such as PV, FV, RATE, NPER, and PMT). You’ll definitely find it very interesting to toggle with your assumptions and play around with numbers.
For starters, you may check out some spreadsheets here. Let me know if you want more.
However it still remains a mystery as how less we know about personal finance. The only solution is to share whatever useful stuff you find.
Some readers have come back to me saying that I should facilitate easy sharing of my content. So go ahead share it with your friends and family
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Manish mailed me with a few questions on the calculations in Option 1. He said,
I would like to calculate it this way … lets say the inflation is 5% , means some thing costing Rs X a year ago is now available at 1.05 * X
Therefore . something which costs 1.05 X today , would have costed X a year before . ( I think you are mistaking it by , X today would have costed .95X a year ago )
Today -> X (this is what we want to find out)
After 1 year -> 1.05 * X (this is 1,00,000 , which will i get from my friend after 1 year , so after 1 year i will buy some thing at 1,00,000 , and today I can buy that thing at X) .
1.05 * X = 1,00,000
X = 1,00,000/1.05 = 95,238
My response to him:
You’re right. But I am talking of Rs 1lakh today (Not X a year ago). The Rs 1 lakh after one year has been discounted at 5% to calculate the PV of Rs 1 Lakh next year. There’s the difference of assumptions. Otherwise the calculations are the same as you have pointed out.
The example was for simplicity sake. If I did the calculations as per your assumptions, there would be need to explain it more.
Do other readers have similar confusion?
As a beginner of the financial concepts it is more useful. i have some basic knowledge of the time value of money. i thank ful to you for the nice presentation.
The saving money could be used when they really need money in such emergency condition. The money would be useful when the unexpected events happen and frequently they don’t have any enough preparation. I personally always save some money even though it’s only a little since I’ve realized this would be useful in the future.