The second attribute identified by Gopi Shah Goda for financial planning is understanding the impact of compounding. As Albert Einstein described it, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Dr Goda estimates that only about 20 percent of the American population accurately understands the impact of compounding, Albert Einstein’s entreaty notwithstanding. Most people widely underestimate its impact – the result of interest being paid (or charged) on interest — even though the basic concepts related to compounding are taught in America no later than the Eighth Grade according to the Common Core State Standards applicable for high school students. The concept of exponential interest — having interest grow on interest – resonates with only a few of us.
Only about 20% of the American population accurately understands the impact of compounding.
Our bias to the present leads us to prefer this evening’s night on the town over tomorrow’s. Combined with an “exponential-growth bias”, we fail to save enough for the future. Dr Goda found that 45 percent of American adults can delay gratification and 20 percent can correctly estimate the impact of compounding on savings. However, few can do both. Dr Goda estimates that not many people have both attributes – ten percent of American adults at the most. The implication is that 90 percent of Americans lack one or both of the attributes needed for long-term financial planning and saving.
Only 10% of Americans are free of both biases.
Still more discouraging is his estimate that if both attributes could be made strong, the amount of increased retirement savings would be just 12 percent over weak skills in long-term financial planning. Dr Goda explains that improving either attribute by two standard deviations in math-speak (or going from the typical level of bias to the 95th percentile) would result in 12 percent additional savings for the future. However the current level of average savings of pre-retirees is just 24 months’ earnings. A 12 percent increase – to 27 months’ income – hardly seems sufficient.
Even if we lost both present-bias and exponential-growth bias, we would only save another 12%.
You might argue that a decade of near zero interest rates on savings has caused Americans to give up including compounding as part of their financial planning. Dr Goda’s work was based on two online surveys, the RAND American Life Panel and the Understanding America Study, administered by University of Southern California. The surveys covered almost 7,000 adults. They were both conducted between August 2014 and June 2015. Nevertheless, we now have a half a generation of Americans who are accustomed to zero interest rates as a way of life.
There must be other ways to get our financial futures ready for their sunset cruises.
Would humor work better?
Some have taken a humorous approach to teaching the need to start saving early. See for example, the 2012 commercial by Norwegian Bank DnBNOR. “Some people have all the luck. [Waking up in a palace, finding that you are married to George Clooney who is planning a romantic holiday for the two of you.] For the rest of us, it would be wise to start saving.
It may also help to be able to visualize yourself at a future date. By being able to imagine yourself as an older person, it is easier to set aside money for that future version of yourself. Read here about an experiment that showed how that worked.
It also helps to build a social network that will support and encourage you in your savings plans. Here are some ideas on why that works.