Majority of people underestimate the power of compounding interest

by | Mar 28, 2022

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As proponents of long-term investing, Orbis Investments set out to test people’s awareness of how powerful compounding growth can be over longer periods of time, by posing a question about a hypothetical long-term investment to a representative sample of UK adults.

Question: You invest £100 on a child’s behalf into the stock market via a Junior ISA. Without using a calculator, what is your best estimate of what the investment would be worth on the child’s 18th birthday if the stock market generates an average annual return of 8%?

Range Respondents’ estimating within range
£100 – No change 16.1%
Between £101 and £150 17.0%
Between £151 and £225 19.5%
Between £226 and £300 16.1%
Between £301 and £375 7.7%
Between £376 and £450 6.6%
Over £450 17.0%

Orbis discovered that only 6.6% of people were able to correctly guess the correct range from a choice of seven options. More than three quarters (76.4%) underestimated the correct amount.

 

The mean estimate was £246, whereas the correct amount was £400, which fell within the range with the fewest estimates.

Dan Brocklebank, Director UK, Orbis Investments said that this tendency to underestimate the power of compounding can lead to poor choices when it comes to long-term financial decisions.

“Our survey confirmed that people still overwhelmingly under-estimate how powerful the compounding effect of growth can be over long periods of time.  Yet, the vast majority of us can afford to take a truly multi-year perspective with our savings.

 

“Compound growth may not be intuitive to most but as long as people underestimate the power of compounding they are likely to miss out on the long-term benefits of investing in markets.  Investing in global equities has been shown to outperform cash over the long term, and the ‘magic’ of compounding plays a part in this.

“The opposite is also true – the penalty for holding cash becomes increasingly damaging over longer periods of time – Interest rates are well below the level of inflation today so the spending power of cash savings is guaranteed to be eroded every year.”

Mr Brocklebank also highlighted some interesting findings uncovered by the research:

 

“Our research shows that women are better at estimating the power of compounding – 27% were in the right range or above, compared to 19% of men. But despite their better awareness, the research revealed that they are less likely to be investing (14% intend to) compared to men (26% intend to invest) due to a combination of greater risk aversion and lack of spare cash.”

“For first time fund investors, or those particularly nervous about current headlines funds with a mix of assets could be an option although you should bear in mind that any investment fund carries the risk that you will lose some or all of the money you invest. , For example, the Orbis OEIC Global Cautious Fund might be a suitable way of benefiting from the compounding effect whilst maintaining a lower risk profile, and avoiding the eroding effects of saving in cash.”

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