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Understanding the Impact of Compounding Increases Savings Rates

Knowing how big of an impact compounded returns will have on retirement savings can prompt investors to save more money. In a study scheduled to be published in the November issue of the Journal of Marketing Research, researchers came to this conclusion after looking into how understanding the exponential growth created by compounding affects savings rates.

The study relied primarily on college students, though employees of a Fortune 100 company were used for one of the experiments. Authors Craig McKenzie of the University of California, San Diego, and Michael Liersch of New York University found that many participants misunderstood compounding and the costs of delaying saving for retirement. They also found that when shown the positive effect of long-term compounding, participants were motivated to increase their savings.

Many college students, and likely many college graduates, incorrectly assumed that savings grow linearly, rather than exponentially. The result was that the median estimate of what an account balance’s size would be was less than 10% of what it would be after a period of 40 years with a given projected rate of return.

Study participants also incorrectly assumed that it is easy to make up for lost time by saving more. Many students, even those who understood how compound returns work, wrongly assumed that they could delay savings until they advanced in their careers. This erroneous assumption can lead to lost cumulative savings that are difficult to make up when periods with high rates of return are skipped.

To determine whether knowing how much one will have at retirement will motivate someone who is currently working to adjust their savings, the authors surveyed employees of a Fortune 100 company. Employees who were shown the estimated account balance of their 401(k) at retirement were more motivated to increase their savings. The authors found that even when the ending balance was larger than needed, participants still wanted to increase their savings.

The study shows that even when the math is understood, many people still have a hard time grasping the concept of exponential growth in savings. The study’s authors concluded that, by showing the dollar-value impact of compounding, individuals can be motivated to save more at an earlier time in their lives.

Source: “Misunderstanding Savings Growth: Implications for Retirement Savings Behavior,” Journal of Marketing Research, November 2011.


Discussion

Chris from NJ posted over 3 years ago:

I have always been amazed that our education system omits basic finance from the High School curriculum. Nearly every person needs to understand how to balance a check book, the damage that credit card balances can do to personal finances, and the benefits of compound interest...I think it was Einstein that called it the greatest mathematical discovery of all time. I applaud the study and the elightenment that resulted.


Kimball from VA posted over 3 years ago:

Chris is spot on. It is almost criminal to not the ABC of finance in Jr and Sr high school (serious study from the seventh grade on and principles of finance in the lower grades.


George f from MO posted over 3 years ago:

What is the engine to compounding if the interest rate is so low that the principal drive is stalled where is the increase in value come from the years your money sets.We need more creditadation for the use of saving or hard earned money that the banks use to run there business and make loans or to pay billions of dollars to their CEO'S where does it credit the customers for their compounding time and goals are short change by the corp.the fianancial system the tax system the corporate loops hole where does are money work where are the benefits. Show me the Fairness or the reward. show me the beef!


Thomas from PA posted over 3 years ago:

Warren Buffett is the greatest example of the miracle of compound interest. He bought stocks that he expected to increase in value at a 20% annual rate . He continued purchasing wonderful companies, that were either undervalued, or growing it's book value and earnings. The continual compounding resulted in astounding wealth. I'm sure most people can't do exactly what he did, but if they followed his general principles, they would achieve a comfortable retirement nest egg.


Chris from NJ posted over 3 years ago:

Thanks Thomas...would like to read more. I've seen many articles on "the Buffett Way" and they add their twist...is there a "real" the Buffett Way that I can get?


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