The time value of money

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Checking, tracking or monitoring prices is one of the first developed consumer mechanisms. We compare the prices to be paid in a neighborhood store with the offers we are inundated with from larger chain stores. However, do we happen to compare prices not only across, but also along? Do we think about how much a TV costs me today, and how much the same equipment cost 2 years ago and also, what will be its price in the future?

Let’s say that the purchase of a TV still classified as a capital good is preceded by a more in-depth retro- and prospective analysis. On the other hand, the situation is quite different for basic goods. I conclude that the most ordinary buyers of sugar at the grocery checkout do not take a reflection on price volatility – that would be absurd, to say the least.

But the point is that sugar, like many other goods, is subject to fluctuating price fluctuations. You may find it hard to believe, but below are compiled 4 different sugar prices from 4 of the most pivotal moments in the history of the Polish economy:

PLN 14,000 – the price of sugar before the denomination of the zloty

PLN 0.95 – the price of sugar after the denomination of the zloty (1994).

PLN 6.10 – averaged sugar price of the current period with inflation of 17.2% (autumn 2022).

PLN 1.90 – sugar price from the deflationary period (2015).

Price volatility

The most important conclusion that comes from this lengthy introduction is the information that both the market and prices, according to the Heraclitean thought panta rhei, are constantly changing. The value of money over time can go up or down for various reasons (not just due to inflation). So, if today I hold in my hand 100 PLN, it is not at all said that in the future this value will not change. In fact, I guarantee you that PLN 100 today is worth more than PLN 100 in 10 years. For this reason, investment science has specified two values of money – present and future.

Capitalization and discounting

The two-way range of price changes is associated with completely opposite operations on money, i.e. capitalization and discounting. The first operation is of an appreciative nature, since due to the accumulation of interest the future value of money increases. In simple terms, by capitalizing one answers the question of how much my bill will be worth someday in X years at a discount rate of Y.

On the other hand, if we already know the future value, we can, through discounting, go back to the present amount by capturing its value. The mechanism of discounting is to look for the answer to the question of how much my future bill is worth today, that is, X years back, at discount rate Y.

A practical example

PV = 100 (2022)
Discount rate (assume today’s inflation) = 17.2%
FV = 117.2 (2023)

My 100 PLN today will be worth 117.2 PLN in a year, as long as I take advantage of the investment benefits.

FV = 100
discount rate = 17.2%
PV = 85 PLN

My future 100 PLN is worth 85 PLN today, which is one year earlier. If I manage 85 PLN rationally today, then I will earn 100 PLN in the future.

The result of the calculation?

After analyzing the mathematical formulas and trying them out in practice, it turns out that the present value (PV), thanks to investment opportunities such as putting savings on deposit, is worth more than the same money in the unspecified future (FV). – example #1

Analogous conclusions can be drawn by analyzing the value of money backward – the future value (FV) is worth less than some present value (PV) today. – example #2

The accentuated aspect of risk and uncertainty plays a significant role in these strict calculations. Ubiquitous risk aversion tends to favor a certain amount today over an uncertain amount in the future. This is discussed more extensively by the developers of the Nobel Prize-winning prospect theory, which explains the issue at hand under the name of the certainty effect.

Worth more today than tomorrow?

The foundation of the theory of translating present value over future value is formed by numerous psychological studies. One of the most popular experiments, the so-called marshmallow test, unequivocally indicated that only 30% of the children tested were able to procrastinate glorification in the form of immediate consumption of a sweet marshmallow. The remaining percentage of children, instead of deferring the consumption of sweets, succumbed to the temptation to eat one marshmallow, i.e. the temptation of present pleasure over greater future pleasure.

Similar patterns become apparent precisely in any changes in the value of money. Today’s investment opportunities offer us not so much as an increase in the value of money, but at least a seed of conditions similar to maintaining the real value of money.

To sum up, the handling of personal finances is the resultant of many factors: attitude to risk, openness to financial market products, consumption tendencies and the psychological building blocks of self-control.

Paulina Słupska

Paulina Słupska

An analyst by education. Although I believe that analysis is the domain of exact scientists, it would not exist without creativity. I try to pour my creative outlook on the world onto e-paper. I'm one of those dreamy pragmatists who rely on constructiveness but, at the same time, let their imagination run wild. In my spare time, in addition to posing questions and refuting theses, I engage in more mundane activities. Sometimes it's yoga, sometimes process automation, sometimes graphic design, and sometimes spiritual development. It varies from time to time.

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