The Miracle of Compound Interest: Does Our Intuition Fail?

Abstract

When it comes to estimating the benefits of long-term savings, many people rely on their intuition. Focusing on the domain of retirement savings, we use a randomized experiment to explore people’s intuition about how money accumulates over time. We ask half of our sample to estimate future consumption given savings (the forward perspective). The other half of the sample is asked to estimate savings given future consumption (the backward perspective). From an economic point of view, both subsamples are asked identical questions. However, we discover a large “direction bias”: the perceived benefits of long-term savings are substantially higher when individuals adopt a backward perspective. Our findings have important implications for economic modeling, in general, and for structuring advice and financial literacy programs, in particular.

Keywords: Behavioral Economics, Financial Intuition, Financial Literacy, Compound Interest, Retirement Saving

JEL Classification: D91, H55