The Amazing Power of Compounding
Compound interest is at the very core of developing an optimal long-tern saving and investment program.
I crossed paths with this fancy-pants term - Exponential Growth-Bias - while reading an article (Wealth Management Section, Don’t Save enough? Perhaps You Have ‘Exponential-Growth Bias’, Wall Street Journal, June 17, 2019) by Dr. Shlomo Benartzi, a professor at UCLA’s Anderson School of Management. The good doctor explained this type of bias as “the tendency of people to neglect the effects of compound interest in their thinking”. So, why do I start bloviating about the potential impact of compound versus simple interest (I call it The Amazing Power of Compounding) in a blog about saving and investing? My reasoning is that a basic understanding of compound interest is at the very core of developing an optimal long-term saving and investment program…and it’s the very reason why my target audiences are our younger generations. Simply put, they have more time to benefit from compounding.
To not appreciate the impact of compounding on a saver’s long-term investment program can have lifelong implications. I will mention compounding time and again in future blogs, but I wanted to highlight it early in my blog’s life, with examples, hoping my youthful audiences will come to appreciate its important role in reaching long-term goals.
Later examples will come but allow me to use a Dr. Benartzi example because it gets right to the point. He asked the simple question, “How much money will you have in your retirement account should you invest $400 a month at 10% for 40 years, compounded monthly?” The correct answer – which adds the interest earned each month to the principal sum, and then calculates the following month’s interest on that amount – is approximately $2,530,000 using Bankrate’s simple savings calculator.
Or more telling, what would be the end result of investing a single dollar at age 20, compounded monthly at 10% until age 65...just one dollar, mind you. The answer: $88.35. If you wait until you’re 40 to invest that single dollar, you would end up with just $12.06 at age 65.
So what’s the big deal? The big deal is that most folks suffer from Exponential-Growth Bias mentioned above… the tendency to neglect or not truly understand the effects of compound interest. Following Dr. Benartzi’s reasoning, they will usually do a quick simple interest mental calculation of $400 x 12 months x 40 years x 1.1, the sum of which is $211,200. In short, people tend to overlook the potential impact of compound interest on long-term investing – much to their detriment.
And Exponential-Growth Bias cuts both ways. Those who suffer from this bias are often guilty of taking on too much debt because they underestimate the true cost of borrowing. Be assured that the Wazoos who loan us money on a long-term basis (mortgage companies, auto companies, etc.) are well-schooled on the benefits of compounding. Who among us hasn’t suffered the shock of the true cost of a home, factoring in 30 years of mortgage payments. Ignoring homeowners’ insurance and property taxes for a moment (which are usually included in a monthly mortgage payment), the ultimate out-of-pocket cost of a $300,000 home financed for 30 years at a 4.5% rate of interest comes to $497,800 (assuming a 20% down-payment). At 5.5%, the cost of that same home almost doubles to $550,600. Whew!
To guard against both sharp edges of the Exponential-Growth Bias blade – the tendency for all of us to save less and borrow more during a lifetime – a clear understanding of The Amazing Power of Compounding is in order. A power that can work both for and against us. Perhaps this brief enlightenment won’t totally solve the problem (you can lead a horse to water… blah… blah… blah), but exposure to the math just might make us consider the true consequences of certain long-term money decisions – of the high cost (and/or rewards) of venturing down such paths. To paraphrase the good doctor, “there’s magic in investing our money and leaving it alone… and of paying down debt as quickly as possible.”