In Equations We Trust? Formula Knowledge Effects on the Exponential Growth Bias in Household Finance Decisions

Abstract

Exponential growth effects play a major role in many household finance decisions. A systematic bias in dealing with exponential growth can lead to poor savings and debt decisions. In this paper, we extend previous research on the exponential growth bias in the savings and debt domains and provide a first experimental link between these two important fields of consumer financial decision making. We develop a measure for the exponential growth bias that naturally extends over different domains and parameter settings, and we explore the ramifications of being acquainted with the basic formula of exponential savings growth. Specifically, we analyze whether such formula knowledge helps only in calculating simple compound interest scenarios with a pocket calculator or if it provides benefits that go beyond this narrow field of application. We observe that—even without a pocket calculator—individuals who know the compound interest formula provide less biased estimates for problems from the savings domain and also for slightly more complicated debt amortization problems that also build on exponential growth effects. We conclude that being acquainted with the compound interest formula provides some intuitive grasp of exponential effects that can be helpful in a broader range of household finance decisions. At the same time, we observe that too much dependence on a calculator can have adverse effects: when equipped with a pocket calculator, a number of participants, both aware and unaware of the compound savings formula, provided persistently insensible answers greater than the initial loan balance in the debt domain.