Summary:
- The Rule of 72 allows you to estimate how quickly you can expect an investment to double.
- It allows you to compare investment portfolios in a quick and simple way.
- It applies to debt and inflation as well, allowing you to pay off, invest, and save accordingly.
- It has its’ limitations, including that it is based off a presumed fixed rate of return.
An Introduction to the Rule of 72
The Rule of 72 is a simple way to estimate how long it will take for an investment to double in value, given a fixed annual rate of return. To utilize the Rule of 72, simply divide 72 by the projected annual rate of return to get the number of years needed to double the amount invested.
For example:
Say you invest $40,000 and predict an annual rate of return of 6%:
After 12 years, if the annual rate of return held true, you would have approximately $80,000.
Note that the Rule of 72 doesn’t factor in how much money you invest, it is a prediction of the time it takes to double your investment, regardless of what the initial investment is.
Simple enough, but how is this useful in financial planning, especially when the annual rate of return is rarely fixed as required by the formula?
Simplifying Estimates and Comparisons
While none of us can predict the performance of any investment, the Rule of 72 provides an easy to calculate and simple to understand illustration of investment performance over time. Given hypothetical and historic investment returns, you can compare potential investments.
For example:
Say you are comparing two investment portfolios, one with a historic annual rate of return of 6% and another with 8%.
Compare these to a 1% annual rate of return savings account:
While these are simplified estimates, the Rule of 72 can help make informed financial planning decisions without resorting to complex calculations. It takes the obvious “the higher the return, the faster the growth” and gives you a better idea of just how much an increase in return helps growth. It’s hard to imagine 6% growth being that much better than 1%, but you can really see the difference in timeframe when you use the Rule of 72. In theory, your account could double in 12 years as opposed to 72!
Other Applications: Debt and Inflation
The Rule of 72 is helpful for more than just analyzing investment opportunities. You can use it to analyze the potential cost of debt and the rising costs that come with inflation.
For example:
Say you have a credit card with an 18% annual interest rate. Using the Rule of 72 you can estimate how long it will take for your credit card balance to double if you don’t pay down the balance.
You can also apply the Rule of 72 to inflation. Assuming that the annual rate of inflation is 3%, we can predict how long it will take for the cost of goods to double. Are you saving for a kid’s education? Want to estimate how much cars will cost in the future? This is a great way to do that easily.
Limitations
Of course, a key component of the Rule of 72 is that it’s based on a fixed annual rate of return, which is unrealistic. Actual investment portfolios are at least variable and at most volatile. So if you want to estimate an investment return or anything else that is not fixed, the Rule of 72 works better over a long time frame, for example over ten years, when we have a much more reliable idea of average returns. We don’t know what inflation will be next year, but we have a very good idea of what the average annual inflation will be over the next 15 years.
The Rule of 72 also doesn’t factor in withdrawals, taxes, or fees which may slow the actual rate of return. For example if you’re expecting an 8% return, but the advisory fee for your investment account is 1%, use 7% as the return instead. Similarly, if your account has $40,000 in it, but you plan on withdrawing $800 each year, that is 2% of the account, so decrease the annual return used in your Rule of 72 calculation by 2. Conversely, if you’re actively contributing $800 per year to your $40,000 account, you can add 2 to the rate of return when utilizing a Rule of 72 calculation.
Financial Planning
As financial planning is concerned, the Rule of 72 is valuable because it allows us to analyze and prioritize how much money we want to have invested in various ‘buckets’ earning different interest rates. What your goals are, your timeline for achieving those goals, how accessible your funds need to be for an emergency, are all factors when determining what funds to place in what investments.
For example, if you’re saving for a down payment for a house, you likely don’t want to wait 72 years for your investment balance to double to meet your down payment goal! In this case, a 1% interest rate saving account may not be the right choice for that goal.
There is much more to investing strategy than the Rule of 72 can solve, but it’s a great tool to utilize along the way. To learn more about how this concept applies to your goals, don’t hesitate to reach out to us here at West Invest.
Important Disclosures:
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments or strategies may be appropriate for you, consult your advisor prior to investing.