The Rule of 72 allows investors to calculate how many years it will take for them to successfully double their money.
For most investors, understanding how your potential investments will perform over a long time period is a challenge. After all, your return on investment may be three to four years away or even longer. I know this may seem like an afterthought but having a general understanding of your portfolios expected growth is paramount if you strive to retire early and reach financial freedom.
Created in the fourteenth century, the rule of 72 is still used by investors around the world to predict their portfolios future growth. By the end of this post, you will fully understand how to implement the rule of 72 to predict your portfolios future value. Furthermore, together we will develop a clear understanding of why this rule is vital to use as an investor.
What is the rule of 72?
As a future or current investor, there is only one rule you absolutely need to be familiar with – The Rule of 72. The Rule of 72 is a simple way to calculate how long it will take for you to double your capital (money).
Ever wonder why some investor, business owners, or banks know exactly when their money will double? Guarantee it is attributed to their calculation of the rule of 72.
Believe me, I am not a math person, but this is one calculation I routinely do. Unlike calculus where we are taking an integral of a function or calculating the area between graphs, rule of 72 is a real-world problem that has practical application.
Before we dive right into the nitty gritty details, lets lay out what the formula is for this crucial rule.
What is the formula?
Like I said, this is not rocket science.
Given a specific interest rate, the rule of 72 allows us to calculate how long it will take for us to double our money. To calculate, we divide our annual interest rate by 72. The result is a rough estimate of how many years it will take us to double our money, or rather, our initial investment.
As you can imagine, the higher our interest rate (or return on investment) then the faster it will take for us to double our money. If we lower our return on investment, then as you can probably guess, the time it takes to double our initial investment increases.
I know the mathematicians or engineers may find this next part a bit confusing, but when you are calculating the rule of 72, make sure to only use whole numbers.
What do I mean by this? In school, we were all taught to convert our percentages into decimal form (7% = 0.07); however, if you do this, then your answer will be completely wrong, so don’t do it!
Examples: The Rule of 72 in Action
Remember, we are not going to convert any of our percentages into decimals. This will provide us with an accurate answer.
|Constant||Annual Interest Rate||Number of Years to Double Investment|
As you can see, the rule of 72 is a great tool to use when predicting the growth of your portfolio over a long-time frame.
Why is this rule so important to Investors?
The rule of 72 is incredibly helpful if you invest in Certificate of Deposits, have a high-yield savings account, money market account, or if you just want to predict the current growth rate of your portfolio.
However, for us to fully understand why the rule of 72 is so important, I want to take this a step further and apply it to a 45-year time frame. Why a 45-year time frame? Assuming you started investing in your early or mid-twenties, then a 45-year time frame is a great estimate for when you will be retirement eligible. Let’s begin.
As a personal finance guru, this real-world example still blows my mind. If only I could see your facial expression, that would make this experience priceless.
For simplicity, here are the parameters we will follow:
- Our account has an initial balance of $1,000.
- Historical Average of 7.0% Return on Investment.
- We contribute an additional $200 a month (or $2,400 annually).
Over the course of 45-years, your account will double about every 10 years (remember 72/7.0% = 10.3 years). This is where the rule of 72 becomes vital. Over 45-years your account will double approximately four times (45 Years/ 10.3 Years = A little more than 4 times). At the end of 45-years your account will be worth a staggering $754,806.68. Don’t get to excited. Here is where it gets even crazier.
The Difference in Value over Time
What if we dialed in our investment strategy and increased our historical average from 7.0% to 8.0%?
When I first got exposed to the world of personal finance, I was oblivious to how much of an impact 1.0% has over the course of 45-years.
If we keep all the other parameters constant and just change our historical average from 7.0% to 8.0%, then our account will now be worth $1,033,743.01 at the end of our 45-year time frame. Yes, that 1.0% difference increased your portfolio value by $278,936.33.
Here is what really happened. That 1.0% increase altered our initial rule of 72 calculation (72/8.0% = 9 Years). And if we take this a step further, that 1-year difference allowed your account to double 5 times over the course of 45-years (45 Years/ 9 Years = 5 Times). For further exploration, feel free to use this compound interest calculator.
The Rule of 72: What is it and Why does it matter in Financial Freedom?
By now, you should truly understand how important the rule of 72 is when evaluating your performance. Just to reiterate, the rule of 72 allows you to calculate the amount of time it will take for your initial investment to double.
If you employ our dollar cost averaging strategy and conduct thorough market research, then you are well on your way to becoming a millionaire. Believe me, a 7.0% historical average is on the low side.
I am confident that everyone who reads this can easily yield anywhere between 8.0%-10.0%. If you thought a 1.0% change made a difference, then I challenge you to calculate what a 2.0% difference does over the course of 45-years.