George Carlin made a great observation: most people will admit to being bad at math, but no one wants to own up to being a bad driver. The problem is most of us are much, MUCH worse at math than we even admit to, and it ends up working against us when it comes to investing. I’m not talking about needing some sort of wizardry with a Texas Instruments graphing calculator that will find the next hot stock, I’m talking about simple stuff like our ability to comprehend the basics of compound interest.
As an example, if I gave you a penny and doubled its value every day for a month (ie on day two it would be worth two cents, day three you'd have four cents, etc), how much would you have at the end of the thirty-one days? Give it a guess, then check out the answer by clicking HERE.
You probably wouldn’t have believed me if it hadn’t been for my highfalutin Excel spreadsheet showing my work (my high school math teacher Mr. Hanson would be so proud!)... and I’m going to go out on a limb here and venture a guess that your answer wasn’t even close.
I see bad mental math like this in action all the time with clients after showing them projections more than a couple of decades into the future. After that amount of time, the power of compounding really starts to kick in and the forecasts can get silly high. Given their brain’s lack of an exponent function, their internal calculator tells them the math has to be wrong. Even after walking them through the calculations, I often get the sense they think it’s a pie in the sky; but if you look back, that’s exactly what has happened in the past. Had my grandparents invested ten thousand dollars into the stock market (what is now the S&P 500) for my father the day he was born, he would have more than forty million dollars today.
Yet another example to give you a math inferiority complex: how many people would you have to invite to a party for there to be a 50-50 chance that two of the guests would share the same birthday? Give it an honest guess then scroll to the bottom of the page… Ok, welcome back and don’t worry, my answer was embarrassingly off as well. So not only are we bad at calculating exponential growth, but we are also terrible at calculating probabilities.
Your inability to accurately calculate odds and gauge risk can get you into all sorts of trouble when it comes to financial planning. For instance, I see clients who tend to focus on life insurance and discount the need for disability insurance, when in reality the statistics show that you are far more likely to become disabled during your working years than you are to pass away. I often have new clients estimate how big of a nest egg they will need at retirement and their answers are often as far off on that as they are on the penny doubling question. And don’t even get me started on how fantastically horrible people are at forecasting the direction of the stock market (especially given their susceptibility to being swayed by the headlines).
So what can you do to compensate for your bad mental math?
Don’t rely on intuition. When it comes to evaluating the probability of a future event, or forecasting how much money you’ll need for retirement, odds are you won’t get it right by guessing. Always dig into the actual numbers (a great job for your friendly CFP!).
Invest early and often. Realize that your brain is likely underestimating how much you stand to gain from doing so… your future self will thank me!
23... Don’t believe me? Just Google “birthday paradox”.