It’s often thought that the wisdom of crowds can be relied on to reach a reasonable level of accuracy for a given estimation challenge. So why does this wisdom fail so spectacularly when it comes to appreciating the maths behind compounding, and its potential effect on investments?
To consider this we need to turn to the snappily titled ‘Misunderstanding Savings Growth: Implications for Retirement Savings Behaviour’ published in the 2011 Journal of Marketing Research. The authors suggest that employees’ failure to appreciate how savings grow over time leads them to grossly underestimate how much money they could have at retirement and this encourages them to put off saving. To demonstrate this, they turned to a ‘crowd’ of undergraduates about to enter the job market and gave them the following estimation question:
If you were to deposit $400 dollars each month, which consistently earned 10 percent annual compound interest, and you did this without fail for 40 years, how much would be in your account at the end of the period? The majority of the undergraduates estimated an amount of just more than $200,000, however the correct answer is just over $2.3 million. So why does the crowd underestimate so significantly when it comes to compounding? It seems most of us are used to linear maths, and struggle to appreciate the effect that exponential growth over time could have on our money.
The way compounding works on your investments is simple. In the first year of investing you generate returns on your initial investment. In the second year you invest the capital plus those returns, and you generate further returns on the total. And so it goes on, helping you to build a bigger pot (if you want to see this in action, with your own figures, we have a handy calculator you can try) . It’s in the later stages of a long-term investment period where the compounding gets exciting, as any percentage growth is being applied to a sizeable pot and the exponentiality really revs up. Now, it has to be said that investing is always subject to ups and downs and so returns are not guaranteed every year. However, patience is key to allowing the compounding maths to work its magic over time, and if you stay invested over a longer-term you are giving your investments a better chance to make up for short-term losses.
This long-term effect of compound returns is perhaps most beneficial when looking at investing for retirement – where the earlier you start the better off you could be. The research group CLSA came to a dramatic conclusion about saving for retirement. They found that if you deposit into a pension from the age of 21 to 30, your pension pot will be worth more than if you saved the same amount each month from the age of 30 to 70. This assumes that you stop contributing at 30, but the fund continues to provide returns at the same rate.
Given this long-term perspective, it can be a good idea to get yourself a firm investing habit; for instance, setting up a direct debit to ensure you make consistent deposits over time. And you don’t have to stash half your income away immediately. If you commit to setting aside as much as you can afford every month and make regular contributions, small amounts can soon add up and you can increase your contributions later, perhaps as your income grows.when you can afford to. The great thing is that Nutmeg will do most of the heavy lifting for you, ensuring your portfolio remains diversified (to spread investment risk and improve your chances of benefiting from potential investment returns) and rebalancing your portfolio to ensure it remains in line with your preferred level of risk over the long-term.
Although central to investing, compounding is the not the only factor it’s important to understand when planning your financial future. Make sure you read the rest of our Investment Essentials series, covering tax wrapper and allowances, and diversification
Risk Warning
As with all investing, your capital is at risk. The value of your Nutmeg portfolio can go down as well as up and you may get back less than you invest. Past performance and forecasts are not reliable indicators of future performance. Tax treatment depends on your individual circumstances and may change in the future.
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