Posts Tagged ‘compounding interest’

Making Smart Decisions

July 15, 2017

This is the twelfth post in the series The Knowledge Illusion: Why We Never Think Alone (Unabridged), written by Steven Sloman and Phillip Fernbach. Making Smarter Decisions is a chapter in this book. Perhaps the one area it is important to make smart decisions is in finance.

Consider the following question: Assume that you deposit $400 every month into a retirement savings account that earns a 10% yearly rate of interest and that you never withdraw any money. How much money do you think you will have in any account (including interest earned): After 10 years, 20 years, 30 years, and 40 years.

Respondents answering these questions responding with a median response of
$223,000.00 after forty years. The correct answer is almost $2.5 million. Use your spreadsheet to prove this for yourself.

HM’s father passed away before he retired, and he was denied a large amount of the pension he should have received. Nevertheless, both his parents had managed their finances carefully. All they invested in were FDIC insured savings accounts and Certificates of Deposit. HM was amazed at the money his Mom accumulated. She was in fine shape, placed no burden on him, and left him a substantial inheritance.

HM’s parents also never carried credit card debt. No one should ever carry credit card debt. This debt is compounded, and increases at a nonlinear rate just as savings accounts do. But unlike savings accounts, debt is subtracted.

Actually the rates that are charged are usurious and should not be allowed. But the financial industry has effectively bought congress. (You should know that the United States has the best congress money can buy). Added to this are the clever programs where you gain rewards for using the card. Using the card and earning rewards is not a problem unless you do not pay off the card monthly when it is due. You should remember if you carry credit debt you are losing money.

Behavioral economics has some effective ideas to aid in better financial decisions (enter, “behavioral economics” into the healthy memory blog search box to find additional posts on behavioral economics). It has found ways to nudge better decisions. Nudging can be done by setting defaults. Rather than have employees opt in regarding retirement contributions, have them opt out if they do not want to contribute. Have being an organ donor being the default option on a driver’s license, and have them opt out if they do not want to be a donor. The big idea of the nudge approach is that it easier and more effective to change the environment that it is to change the person. Once we understand what quirks of cognition drive behavior, we can design the environment so that those quirks help us instead of hurting us.

We can apply these lessons to how we make decisions as part of a community of knowledge. Realizing that people are explanation foes—that we usually don’t have the inclination or even the capability to master he details of all our decisions, we can try to structure the environment to help ourselves make good decisions despite our lack of understanding.

Reduce Complexity
Simple Decision Rules
Just-in-Time Education
Check Out Understanding


© Douglas Griffith and, 2017. Unauthorized use and/or duplication of this material without express and written permission from this blog’s author and/or owner is strictly prohibited. Excerpts and links may be used, provided that full and clear credit is given to Douglas Griffith and with appropriate and specific direction to the original content.