How to get your head around some basic financial concepts
Do your eyes glaze over when you hear financial terms like net present value or accrued interest? Do you run a mile when someone starts talking about an Equivalent Annual Rate? If that sounds like you, then you’re in luck. This article will explain the three concepts on which nearly all other financial concepts are based. If you can get your head around these three ideas, everything else will make a lot more sense.
The three concepts are:
- Time value of money
- Supply and demand
Time value of money
Time value of money concerns the interest you pay on a loan and the interest you receive on a deposit, and boils down to the idea that money available right now is worth more than the same amount in the future due to its potential earning capacity. If you understand this idea, then a lot of the other terms you’ll find in our glossary will begin to make more sense.
If you have £100 and you keep it in your wallet, in a year’s time it will still be £100. However, if you put it in a savings account at a bank, you could earn up to 2.45% interest, which would mean the present value (PV) of £100 would grow to the future value (FV) of £102.45.
If you borrow money, you receive the present value but owe the future value of that amount, and that future value depends on the interest rate you pay. If you have a credit card and go over your overdraft limit, you’ll pay a higher rate.
If you lend money or if you put money in a savings account that amounts to the same thing, you lend the present value and receive the future value in return.
If you keep that money in your wallet, you miss out on the interest – this is known as the opportunity cost. You also have an opportunity cost if you spend the money on a car, or if you invest the money in stocks, real estate, or any other asset. All investments are therefore measured against their opportunity cost, which is the FV minus the PV.
If you flip a coin, there’s a 50% probability it will land on heads, and 50% chance it will land on tails. If you randomly draw a playing card from a 52-card deck, there’s a 25% (13/52) probability it will be a Spade, a 7.7% (4/52) chance it will be a Jack and a 1.9% (1/52) chance it will be a Jack of Spades.
Probabilities are very similar to betting odds. If you head over to a betting site and place a bet on a football team at 3 to 1, you will win three times your bet if your team wins. That means the bookies, or the other people betting, think there is a 1 in 3 chance of the team winning. That’s the same as a 33.3% probability.
Probabilities are important because they are used to weigh up the risk of loss. Rather than putting your £100 in a bank account to earn £2.75, you might decide to place that money on a bet at 3 to 1 odds. After all, you could win £300. But you only have a 33.3% chance of winning that money. If you put your money in the bank you have a 100% chance of getting it back with interest. Even if the bank goes out of business, deposits of that size are guaranteed by the government.
Trading is almost always based on probabilities, as are derivatives and insurance.
Supply and demand
While time value of money and probabilities determine the way people value investments, the price is determined by supply and demand. Ultimately, it is supply and demand that determines the price of shares, real estate, currencies and even cryptocurrencies. If there is more demand than supply at a particular price, the price will rise until demand and supply are balanced. If there is more supply, the price will fall.
The price of Bitcoin has risen because demand is rising faster than supply. While new buyers enter the market, only about 2,000 new coins are mined every day. And that number decreases each day too, while the number of buyers increases. There will only ever be 21 million Bitcoins in existence. You can see the number of coins that have already been mined here – as of 5 December 2017, it was 16,724, 000.
The time value of money allows one to choose between one investment and another, probabilities allow us to weigh up the risks of various investments, and those factors influence supply and demand, which ultimately determines prices. If you can get your head around those three ideas, almost any concept in finance will make sense to you.