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. 1
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: