When we start on our savings journey and consider investment plans, it’s natural to feel stressed by the bombarded options and conflicting advice. The human tendency to overthink can lead to confusion, especially with the conflicting information available. However, amidst the confusion, there’s a valuable tool that can simplify our understanding of how money grows over time – the Rule of 72.
In this blog, let’s understand the Rule of 72, which will help us estimate the future value of an investment with ease. Understanding and applying the Rule of 72 can be a game-changer in making informed investment decisions.
So, what exactly is the Rule of 72?
It’s a quick and easy way to estimate the number of years required for your invested money to double. By dividing 72 by the annual rate of return, you get a rough estimate of the time it will take for your initial investment to replicate itself.
Are you still confused? Let’s break it down into a formula for your better understanding.
The formula for calculating the doubling time in years using the Rule of 72 is expressed as follows:
By dividing 72 by the rate of return, you can determine the approximate time it will take for your assets to double. The result can be obtained in days, months, or years, depending on the presentation of the interest rate.
For example, you can input the annualized interest rate into the formula to find out how many years it will take for your investment to double.
Consider having an investment with an annual interest rate of 8%. Using the Rule of 72 formula, you can estimate the time it will take for your investment to double:
T = 72/R
Substitute the interest rate (R) with 8:
T = 72/8
Calculate the result:
T = 9
So, according to the Rule of 72, your investment would take approximately 9 years to double at an annual interest rate of 8%.
Hopefully, the calculation above has shed some light on the Rule of 72 for you. In the upcoming sections of this blog, we’ll delve even deeper into the Rule of 72, providing you with a comprehensive understanding that can guide you in making more confident decisions.
How the Rule of 72 works
- When talking about interest rates, it's better to use whole numbers, like 7, instead of decimals out of 1, such as 0.07 for 7%. For example, if you calculate 72/7, you get 10.3, or just 10.3 years.
- When it comes to continuous compounding interest, using 69.3 instead of 72 gives you more accurate results. The Rule of 72 is a quick estimate, but 69.3 is more precise, although a bit trickier for mental math. If you're using a calculator, go with 69.3 for slightly better accuracy.
- The further you deviate from 8% return, the accuracy of your results diminishes. The Rule of 72 is most reliable within the 5 to 12% range that is also an approximation.
- When dealing with a lower interest rate like 2% tweak the Rule of 72 by reducing it to 71. On the flip side, if you're working with a higher interest rate, say 18% again tweak the Rule of 72 by adding one for every 3% points. For instance, use 74 when calculating the doubling time in this scenario.
Accuracy of Rule of 72?
| Rate of Return | Rule of 72 (Years) | Actual # of Years | Difference (# of Years) |
|---|---|---|---|
2% | 36.0 | 35.0 | 10 |
3% | 24.0 | 23.45 | 0.6 |
5% | 14.4 | 14.21 | 0.2 |
7% | 10.3 | 10.24 | 0.0 |
9% | 8.0 | 8.04 | 0.0 |
12% | 6.0 | 6.12 | 0.1 |
25% | 2.9 | 3.11 | 0.2 |
50% | 1.4 | 1.71 | 0.3 |
72% | 1.0 | 1.28 | 0.3 |
100% | 0.7 | 1.0 | 0.3 |
How does it Apply to Stocks?
As you move forward with your saving plan, especially if you’re a stock market investor, you might have questions about whether this rule applies similarly to stocks or not. Don’t worry; we are here to provide you with the clarification you need.
So, when it comes to stocks, they don’t have a fixed rate of return like some other investments. This means you can’t directly use the Rule of 72 to figure out how long it takes to double your money.
However, here’s a trick you can use with the Rule of 72 to estimate the average annual return needed to double your money in a set timeframe. Instead of dividing 72 by the rate of return, divide it by the number of years you hope it takes to double your money.
For example, if you want to double your money in eight years, just divide 72 by eight. This calculation tells you that you’d need an average annual return of about 9% to achieve that doubling in eight years.
So, while the Rule of 72 may not directly predict doubling time for stocks, it can help you estimate the required average annual return for your investment goals.
Benefits of Rule of 72 in Investment Strategies:
You now have a better grasp of the Rule of 72 and its advantages. To shed more light on the benefits, let’s explore some additional reasons why this rule is widely embraced by investors.
- Investors can quickly apply the Rule of 72 as it offers a straightforward approach.
- This rule allows investors to adapt their positions and manage risk based on changing circumstances.
- It can be used with various market variables, such as GDP and population growth, as long as there's a known annual interest rate.
- Investors find it beneficial to estimate how long it will take for their invested money to double.
- The rule provides a precise timeframe, helping investors plan when to sell investment securities for a profitable two-to-one return.
Drawbacks of the Rule of 72
In our previous discussions, we delved into the advantages of the Rule of 72 in estimating the time it takes for an investment to double. Now, let’s turn our attention to its limitations. This rule, while handy, has certain drawbacks.
- Investments with simple interest and variable interest rates don't align with the Rule of 72's assumptions.
- While effective for lower rates of returns, the rule provides an approximation, not an exact timeframe for doubling an investment.
- Beyond certain thresholds, the Rule of 72 may not accurately predict the doubling time, introducing potential deviations.
- Any unexpected increase in the interest rate can render the Rule of 72 invalid and less reliable for future predictions.
Happy investing and thank you for reading!
Disclaimer:
This website content is only for educational purposes, not investment advice. Before making any investment, it’s important to do your own research and be fully informed. Investing in the stock market includes risks, and you should carefully read the Risk Disclosure documents before proceeding. Please remember that past performance doesn’t guarantee future results, and due to market fluctuations, your investment goals may not always be achieved.
