Here’s a question: a bank pays you 15 per cent interest every year. Will you get the same or more interest in the second year?
Hopefully, most readers will have worked out that the second year brings more, because compounding means your interest earns interest. However, many people get this wrong, with a recent study finding only 37 per cent of Romanians and 47 per cent of Japanese answered correctly.
Ireland fared better (71 per cent), with the highest scores in Israel and Norway (88 per cent) and Sweden (87 per cent).
The more interesting part, however, is that an inability to grasp compounding may come with surprisingly large market consequences.
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The researchers suggest this blind spot is linked to the dividend yield anomaly, the tendency for high-dividend stocks to outperform what their price alone would suggest. They say that in low-literacy markets where investors misunderstand compounding, this effect is over three times as big as in numerate regions.
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And don’t assume this simply reflects small or less-developed markets, because the pattern shows up in some very sophisticated ones too.
Take Japan. As noted earlier, Japan scores poorly on financial literacy, despite the country being wealthy and having one of the world’s most developed stock markets. The study suggests this helps explain why Japanese high-dividend stocks remain unusually cheap, with local investors underestimating the long-term value created when dividends are reinvested, leaving bigger returns for those who do the sums.
Markets may be sophisticated machines, but they are still powered by humans, and humans can sometimes underestimate the surprising power of compounding.
