Exponential growth bias
Behavioral New World
The Miracle of Compound Interest
April 1, 2021
You’ve probably heard of Warren Buffett, a famous investor, famous because of his financial success. Investors, journalists, and analysts have paid a lot of attention to his style of investing in the hopes of mimicking that success. The university where I teach even has a course called, “The Investment Philosophy of Warren Buffett.”
However, there is a second, overlooked, factor in his success: He has been investing for a long time. He is currently 90 years old and started investing when he was 10 years old. This longevity has allowed him to capitalize on something called “compound interest,” the earning of interest in later periods not only on the initial investment, but on the interest earned in earlier periods as well (“interest” here can be broadly interpreted to mean “return on investment”). How important is this? Compound interest has been described as “the eighth wonder of the world.”
Compound interest is an example of exponential growth, any process that has a fixed doubling time. It starts off slowly and then accelerates dramatically. Here’s a link to see what exponential growth looks like (my hand drawings were just too pathetic):
https://en.wikipedia.org/wiki/Exponential_growth
The Rule of 72 gives us the doubling time for compound interest: Divide 72 by the percent interest rate and you get (to a reasonable degree of accuracy) the number of years it takes to double your money. For example, at 10%, your money will double approximately every seven years. Because compound interest is one type of exponential growth, failure to appreciate its power is sometimes called exponential growth bias.[1]
Let’s consider three examples to illustrate the importance of compound interest.
First, as of September 2020, Warren Buffett was worth about $81 billion(!). However, about $70 billion of that came after he turned 65.[2] Why? Did he suddenly become better at investing? No, he has hung in there long enough to reach that accelerating part of the exponential growth curve. Remember: He started when he was 10 years old. Playing the long game has worked well for him.
Second, consider saving for retirement. If you put aside $200 per month and earn an annual return of 10%, you’ll have approximately $1.26 million after 40 years (this calculation admittedly ignores taxes). I hope you’re impressed that a relatively small amount of investment can yield an impressive outcome, given the power of compounding and enough time to let it work.
Now suppose you have a goal of amassing $1.26 million, but only have 20 years to do it. How much will you have to save each month, assuming the same 10% annual return? Not twice $200, not even close: It will take $1666! That’s quite a penalty for waiting 20 years to start your investment program. The extra 20 years that you gain by starting early really makes a difference. And it does so because you’re earning returns on earlier returns—the “miracle” of compound interest.
Third, the same math applies to debt. If you don’t pay it back promptly, it will grow exponentially. Yikes! None of us wants to end up $1.26 million in debt simply because we borrowed $200 a month, but that’s what would happen.
When you’re investing, exponential growth is your friend; when you’re borrowing, it is your enemy.
The consequences? Research has shown that people who have exponential growth bias save too little, for the simple reason that they underestimate the power of compound interest—they don’t think it’ll make much of a difference to start early and modestly. Start investing early (and encourage your children to).
Exponential growth bias also leads people to borrow too much because they underestimate how the debt can accumulate over time.
It was Albert Einstein who described compound interest as the eighth wonder of the world. Exploiting the power of compound interest won’t mean that your portfolio will grow at the speed of light but, given enough time, it will grow to a relatively impressive amount.
[1] “Exponentially” is also used casually to describe any rapid-growing phenomenon. For example, a recent headline on the BBC website declares, “Coronavirus cases are rising exponentially in Germany.”
[2] https://www.cnbc.com/2020/09/08/billionaire-warren-buffett-most-overlooked-fact-about-how-he-got-so-rich.html