While much of money management is managing emotions, a part of financial planning is based on mathematics. But fortunately the mathematics is not really complicated. You probably learned the basic principles in school.
For example, one of the concepts is that principal multiplied by interest rate over time equals interest earned. Interest = Principal × Interest Rate × Time. You read about that in class 5!
Mathematical reasoning is necessary all through life. This ability also affects decisions we make in personal finance. So it is a good idea to understand/revisit the basic principles of math that you need to understand in order to manage your finances. And these concepts can help you with all your financial decisions like retirement planning and planning for your investments.
Let us start with some understanding of the time value of numbers. Let’s play with numbers!
Let me take a simplistic example to understand the time value of money. 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 Mutual Fund/Stocks which can give you a return ranging from -50% to +50%
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?
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.
As part of the mathematics of financial planning, we will discuss a few things like the power of compounding and cost averaging. Stay tuned.