Cornell University Johnson at Cornell University

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"If you don't know your math, you'll end up taking a bath"

knowyourmath_illustration

So reads the Wall Street Journal headline on January 16, 2008. How much basic finance do you remember? In a recent study, marketing professor Eric Eisenstein found that people's lack of math skills negatively affects their handling of such basic savings and loans concepts as simple versus compound interest. Eisenstein found that most people estimate compound interest by anchoring on simple interest and insufficiently adjusting upward. The result? Large prediction errors, particularly when the timeframe is long or when the interest rate is high.

According to the working paper "Intuitive Compounding: Framing, Temporal Perspective, and Expertise," a better strategy is to use the Rule of 72. For reasonable rates of return ( r ), the time it takes to double your money is given approximately by 72 / r. For example, if you wanted to know the approximate future value of $100 invested for 24 years at 9% interest, first divide 72 by the interest rate (72 / 9 = 8 years). Then find the number of doublings (24 / 8 = 3). Your money will double three times over the investment period, so you will have approximately $800 at the end of 24 years ($100 * 23 = $800).

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