If You Want to Build Wealth, Improve These Two Math Skills
People struggle with numbers that grow or shrink really fast and it hurts their wallet
Mathematics is not about numbers, equations, computations, or algorithms: it is about understanding. — William Paul Thurston
Building wealth is an extremely simple exercise.
There are only two things you can do to increase your net worth; reduce your debts, and increase your assets.
Every blog post and book about personal finance has advice about how you can pay off debt and save more money.
A much more helpful question that personal finance authors often ignore is this:
What factors drive a person’s decision to take out a loan or save money?
In this edition of Money On My Mind, I review a lesser-known cognitive bias that helps explain why people borrow too much and save too little — and more importantly, I discuss two simple solutions to help you build your wealth.
Money = Math
Here’s a point that I’ve made in the past and will continue making regularly because it’s essential and not talked about nearly enough:
If you want to get better at managing money, you’re better off cracking open a gradeschool math textbook than reading a personal finance book.
This is coming from a guy who sells personal finance books!
It’s not that personal finance books are useless; it’s about building basic skills required to manage money before you try and execute a financial plan.
There is no way about it; managing money means understanding math.
I am not talking about advanced math; I mean basic math, like understanding percentages and compound interest.
If you don’t understand these basic math concepts, you will struggle with money and make many unforced errors.
A case in point is this 2008 paper which details how a lack of understanding of how interest rates and compound interest work leads people to take on too much debt and save too little money.
The researchers found that people tend to underestimate how much money they will have in the future through saving and investing.
The biggest problem is that most people don’t understand compound interest. They think of interest as a constant instead of compounding. The longer the timeline, the more they underestimate the benefits of saving and investing.
Let’s say you have $100 today, and you will earn 5% annual interest on that money every year.
When I say many people think of interest as “constant,” they look at the interest they receive in the first year — which in this example is $5 — and project forward that each year they will earn $5.
Except they won’t because the money compounds.
In the first year, they would earn $5. But in the second year, they would earn 5% on their initial $100 investment and 5% on the $5 in the interest they earned in year one. The difference starts out small but adds up over time, as illustrated here:
We underestimate the benefits of compound interest, which leads us to underestimate the benefits of saving money.
There’s a similar issue with how people perceive the cost of debt; they consistently underestimate the interest rate they pay on their loans.
Interestingly enough, the shorter the repayment time for the loan, the more people underestimate how much interest they pay. This happens when we don’t realize that the principal declines quickly on shorter-term loans.
To quote the researchers:
“Consumers overestimate how long they actually get to borrow the principal, thereby underestimating the true cost of borrowing. Payment/interest bias is more severe on short-term loans because principal balances on those loans decline faster than on long-term loans.”
The researchers attribute these errors in assessing the benefits of saving and the cost of debt to a cognitive bias called exponential growth bias, which is a fancy way of saying people struggle with numbers that grow or shrink really fast.
The result? More debt and fewer assets
Here’s what all this means for people who struggle the most with making sense of compound interest and understanding debt repayment terms.
They have:
- Less money saved
- The money they do have saved is in less risky assets — which means lower returns on their savings.
- More debt
- Specifically, they have more short-term debt, meaning they end up paying more in interest than they think.
It should come as no surprise that this all means the people who struggle with exponentially growing numbers have a significantly lower net worth.
How to fix the problem
With a problem that is technical in nature, there are only two solutions
- Outsource the problem to a 3rd party
- Work on improving your technical skills around this type of math
The researchers in the paper I have been referencing found that this problem essentially vanishes when someone gets financial advice.
To quote the paper:
“More-biased households who get outside advice are just as wealthy as the least-biased households”
Makes sense to me. If you struggle with the technical aspects of financial planning, hire an expert to do it for you.
It was unclear whether that financial advice had to be through a financial advisor — but if you can afford it, that would be your surest bet.
At the risk of seeming self-aggrandizing, reading a publication like this one is another good option to help work through these types of financial issues if you can’t afford to hire an advisor.
This research speaks to a broader issue of the importance of understanding math to be great at managing money.
You do not need to be a mathematician or be able to work out complex formulas, but you have to understand the basics of debt repayment and compound interest. If you sharpen that two math skills, you’ll dramatically improve your odds of building wealth.
Your Brain Is Secretly Sabotaging Your Financial Plan
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.
