Why Do We Keep Failing to Teach and Understand Compound Returns?
By Dan Kadlec
November 21, 2016
Compound growth is a fairly simple concept. Yet time and again in surveys and financial literacy assessments young people fail a simple question on this topic.
In a new survey from Natixis Global Asset Management, active participants in an employer sponsored savings plan were asked: beginning with $100 compounded at 5% annually, how much would your investment be worth in five years? Only 55% correctly answered the total would be a little more than $125.
Similar questions were posed in a high-profile financial literacy assessment that Standard & Poor’s, Gallup, the World Bank, and George Washington University Global Financial Literacy Excellence Center released last year. The survey asked adults in 140 economies two questions on the topic:
Suppose you put money in the bank for two years and the bank agrees to add 15% per year to your account. Will the bank add more money the second year or will it add the same amount both years? (More.)
Suppose you had $100 in a savings account and the bank adds 10% per year to the account. How much money would you have in the account after five years? (More than $150.)
On both questions, the results were similar to the Natixis survey—about half got it right. Other surveys over the years have shown more of the same. It’s not clear why compound growth is such a vexing topic. In basic form, like the questions posed above, this is fairly simple math.
The failure rate as it relates to compound growth may help explain why we have a retirement savings shortfall. Young people who have the most time to benefit from compound growth don’t understand the value of starting early.
In making a case for greater efforts at financial education in schools and the workplace, Natixis noted that nearly half in the survey did not know how much they needed to save each year to hit their end goal. Again, this is simple compounding. You don’t even have to understand how it works. There are many serviceable online calculators for that. You just have to know that it works, and then get started. A little financial education goes a long way.