A new study explains why Americans aren’t saving money: They are procrastinators who don’t understand math.
Yes, it’s a sad state of affairs. The two-fold problem, according to the study published in the National Bureau of Economic Research, is that Americans like to put off until tomorrow what could be done today, and compounding interest is an illusion to them.
The study’s authors defined these two defects as present bias and exponential growth bias, respectively. Present bias is pretty easy to grasp. We say we’ll do something as long as we don’t have to start this second. For something like saving money, tomorrow never comes.
‘Present bias’ refers to the tendency, in evaluating a trade-off between two future options, to give stronger weight to the earlier option as it gets closer. An individual with present-biased preferences might express willingness to invest a tax refund she will receive in six months in a retirement savings account, for example, but when the refund arrives she will prefer not to do so, even though nothing has changed except the passage of time. This individual will save less for retirement than another who also favors investing the tax refund (who has the same long-run ‘discount rate’) but does not suffer from present bias and thus does not change her mind as the refund date nears.
The exponential growth bias is a little sadder, explains an enlightening piece published in The Atlantic:
Exponential growth bias, isn’t a cognitive bias, perhaps, so much as a failure of math. They found that 75 percent of participants in their study didn’t understand compound interest, the principle that even small annual growth over a long period of time yields surprisingly great returns.
It’s intuitive to most young people that saving $100 now is better than saving $100 the year before they retire. But most people underrate the benefits of compounding interest. Saving $1 at the age of 20 is twice as valuable in retirement as saving $1 at the age of 40.
The rule that has stuck with me (although I can’t remember where I heard it) is the 2-20-50 rule. Two percent annual growth might sound shockingly meager. But a sum of money that grows by 2 percent each year for 20 years will have increased by about 50 percent.
The shocking part is how these biases affect the bottom line. According to the study’s authors, people had higher retirement savings when they were aware of the bias, even controlling for the effect of income, education, risk preference, financial literacy, IQ, and other characteristics.
A two-standard-deviation increase in either measure of bias (equivalent to moving from a typical level of bias to the 95th percentile) would decrease retirement savings by about $26,000, or about 20 percent relative to the mean value of $133,000.
Overall, eliminating both biases from the sample would lead to a 12 percent increase in retirement savings, the authors estimated.
