What is depreciation?
Depreciation is a decrease in an asset’s value caused by wear and tear, age, or changes in the market. There are two primary ways in which depreciation is commonly understood. The first way is a method for investors to write off certain taxes, and the second way is the process by which an asset decreases in value.
There are four methods used to calculate depreciation:
- Straight-line depreciation. This is the simplest type of depreciation. The asset is depreciated evenly over its useful life.
- Declining balance depreciation. With this method, the asset is depreciated more in the early years and less in later years.
- Sum of the years’ digits depreciation. This method considers how many years the asset has been in use.
- Units of production depreciation. This depreciation method depends on how much the asset is used.
Several factors can cause depreciation:
- Physical deterioration. This is caused by wear and tear, age, or weather. Physical deterioration is the most common cause of depreciation.
- Functional obsolescence. This is when an asset becomes obsolete because a newer, better model comes along.
- Economic obsolescence. This happens when an asset becomes outdated or no longer needed because of changes in the market.
- Legal restrictions. These are laws or regulations that prevent an owner from using an asset in a certain way. For example, zoning laws might restrict how much an owner can demolish a building.
To calculate depreciation, you need to know the following:
- Purchase price of the asset.
- Salvage value (how much the asset is worth after depreciation).
- The number of years the asset will be used.
There are several things you can do to reduce the risk of depreciation in your portfolio:
- Buy assets with a high salvage value.
- Purchase assets that have a long useful life.
- Make sure your assets are well-maintained.
- Use inflation hedges to protect yourself from rising prices.
- Invest in assets that are not subject to legal restrictions.
- Diversify your portfolio to reduce the risk of any one asset experiencing depreciation.
There are a few types of investments that have low depreciation:
- Real estate. Properties tend to maintain their value over time, so they experience little depreciation.
- Precious metals. Gold, silver, and other precious metals usually do not lose value over time.
- Fixed-income investments. Bonds, CDs, and other fixed-income investments typically don’t lose value over time.
There are a few types of assets that experience high depreciation:
- Vehicles. Cars, trucks, and other vehicles tend to lose value quickly.
- Technology products. Gadgets and electronics usually have a short lifespan and depreciate rapidly.
- Renewable energy sources. Solar panels, wind turbines, and other renewable energy sources often experience rapid depreciation.
Depreciation case study
Joe bought a brand new car for $50,000. The vehicle can last for 200,000 miles, lasting Joe five years based on his daily driving amount. At the end of the five years, once the car has reached its limit, its salvage value will be $15,000. To calculate depreciation, you would use this formula:
Depreciation = (purchase price – salvage value) / number of years used
So in this case, depreciation would be ($50,000 – $15,000) / (5 years). This would give you a depreciation amount of $7,000 per year. In this case, the value of Joe’s car after one year would decrease to $43,000 and decrease by $7,000 each year after.
The bottom line
Depreciation is a decrease in the value of an asset. Several factors can cause depreciation, but physical deterioration is most common. To calculate depreciation, you need to know the purchase price of the asset, its salvage value, and how many years it will be used. To profit from your investments while minimizing the risk of depreciation, it is essential to diversify your portfolio and invest in assets that have a low depreciation rate.