When you boil it down, any investment decision comes down to two concepts. Firstly, you need to be able to calculate the present value of what you believe that investment to be worth. Only by calculating the expected future value of an investment, can you compare it to a 1-year cash deposit, a 10-year government bond, or another investment. The first concept to understand is time value of money.
To calculate the present value of a future cash flow, you use this formula:
PV = FV/(1+r)n . FV is the future value, r is the interest rate for each period, and n is the number of periods. So, the present value of a $100 cash flow a year from now, with a 5 percent interest rate, is:
PV = 100/ (1+0.05)1 = 100/1.05 = 95.2.
If all that’s a bit much, you can use this calculator.
The second concept is probability. Just because something is possible, it doesn’t mean its probable. At the same time, even if an investment doesn’t have a high probability of achieving a specific return, it doesn’t mean it’s a bad investment – provided the return is enough to compensate for the risk.
In many ways, probabilities are the same as betting odds. Any form of betting, whether it’s sports betting or gambling in a casino, revolves around probabilities which are expressed as odds. Bettors compare the odds for various sports and casino games on sites such as Oddschecker in order to improve their chances and understand the likelihood of winning better.
If something has a 10 percent probability of occurring, it has very low odds of happening. In fact, it has a one in ten chance of occurring. If something has a 90 percent probability of occurring, it has high odds of occurring. But, there is still a one in ten chance it won’t occur.
By combining time value of money and probability, you can compare investments with different risk profiles and different time horizons. If you can get your head around these two concepts, you will be able to understand just about any concept related to investing.
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