Wednesday, January 23, 2013

Discount Rate

In the world of value, specifically money and investing, but really anything with present and future value, there is something referred to as the discount rate. Basically, it refers to how something increases in value over time. The specific rate can be a significant issue, especially in the insurance industry. This also makes a huge difference in the pension, annuity, and social security actuary scales. However, on a more human level it makes a difference too.

When determining how to spend my time who and what is more important? There are many variables of course, but take the hypothetical example of a girlfriend. I have no idea how her value to me might increase over time, but the possibility of an increase daily over 60 years means that even a relatively minor value now is huge. Similarly, my sister has been my sister for over two decades and will be for 5 or 6 or more. Similarly, to me the value of racing in the Olympic Marathon Trials means that today, I have to get out there and perform at a certain level. I may have years, but I need to be at a high level today because I can only improve so fast, perhaps only 3% per year or even 1%! You can think of this in weight loss too, if your goal is to average three pounds of weight loss per month through five hours of exercise per week for one year you can start with only three or four hours of exercise per week and maybe not lose weight or only one pound the first month. That is fine because as your fitness and exercise regimen ramps up according to a discount rate you will lose more weight later in the program.

This brings up the other aspect, at some point in many situations we have achieved maximum value. In other words at some point in weight loss perhaps you are losing five pounds per month and at that point get to some moderately fit level. Your weight loss per month will decrease after achieving your maximum loss rate and low future weight to lose. It is the same for athletics. At some point a 1% increase in performance will require 50% more effort.

In short, values typically increase over time. Thus all things being equal the younger person performing at the same level as an older person may in fact be worth more for the probable future increase in value. Obviously that is an over simplification. The ways that a person might increase in value are difficult to estimate. Thus that is why we generally, and appropriately, give attention and economic value (money) to those that have demonstrated past value. Somewhere in the mathematical world of past demonstrated value and future possible value exists significant value, which may in fact be undervalued.

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