How the brain tricks us out of turbo-charged interest
16 October, 2015
Apparently the human brain is capable of 1016 processes per second, making it more powerful than any computer in existence. But for all its efficiency, the human mind is flawed with biases that lead to us making questionable decisions.
When it comes to saving and investing, our tendency towards overconfidence and our inability (or unwillingness) to think very far into the future can be seriously detrimental. While our minds might be hardwired to help us survive each day, they're not so flash when it comes to our long-term financial survival.
We've all heard of the concept of compound interest, and it is hard to argue with Albert Einstein who called it the eighth wonder of the world.
Compounding is essentially earning interest on interest. Your returns get turbo-charged as you earn interest not only on your capital but also on the interest that you have previously earned.
According to economists from the London School of Economics, one in three people are completely flummoxed by the concept of compounding and can't understand the notion of exponential growth.
I think it's because the magic of compounding lies in small, incremental gains over time, whereas most people prefer, and are confident that they can achieve, big gains quickly.
Often examples of compounding use small numbers in order to illustrate the simplicity of the concept. But small numbers extrapolated over long time periods don't excite anyone.
For example, it is hard to be inspired by an example of a $2,000 bank deposit earning 5% interest per annum. After the first year, the bank pays you $100 in interest. The following year, your starting balance will be $2,100 so the bank will pay you $105 in interest, with the extra $5 representing the value of compounding. Woo hoo!
Compounding looks more interesting over longer periods of time. Thanks to compounding, your $2,000 initial investment will double in about 14 years, even with just a 5% interest rate. And it would earn twice as much interest between years 15 through 28. By year 29 you'd effectively be earning 20% interest on the original investment. Surely that's a little bit exciting?
I think that to get people inspired by the magic of compounding — and it really is magic - we need some more exciting examples.
Here's one that's interesting, despite it using small numbers. While a 2.5% return is underwhelming on the face of it, you'd achieve a 65% return if your investment grew by 2.5% every day for 20 days. A full year of 2.5% daily returns would yield a return of more than 50,000%!
And what about the legend of the inventor of chess? Apparently he was granted any wish by a grateful king, and asked to be rewarded with one grain of rice on the first square of the chessboard. The amount was then to be doubled on each successive square. The king agreed, thinking he would have to pay a few handfuls of rice. He was shocked to discover that by the 64th square — thanks to compounding — he would owe the inventor enough rice to carpet the entire planet!
The magic of compounding lies not in the scale or the timeframe — of your investment or your rate of return — but in the simplicity of growth upon growth. Don't let your brain convince you otherwise.