Thursday, February 21, 2008

People just don't get compound interest.

Compound interest is a wonderful thing, but I always suspect that people just don't get how powerful it really is. One prediction of this is that individuals think that credit card debt is easy to pay off, and that there is not that much benefit from starting to save early.

This paper shows that households do in fact behave in this way, and they offer a theory for why.

But perhaps the simplest illustration of the effect of compounding is the following. Consider $10,000 invested for 10, 20, 30, and 40 years at 10%.

10 years: $25,930
20 years: $67,270
30 years: $174,490
40 years: $452,590

The question then is: If someone gives you $10,000 what should you do with it?