What is the rule of 72?
The rule of 72 has to do with the rate at which an investment compounds.
But what is the rule of 72? It's a quick mathematical fomula that tells us how quickly it will take an investment to double in value given an interest rate and a period rate.
The specific formula is:
72 / ROI = # of periods to double
Let's use an example:
You have a 7.2% annual return, on average. That goes in the first spot, like so:
72 / 7.2 = # of years (since your return is annual) to double.
At this rate of return, it will take 10 years to double your investment. It's important to note that this includes compounding.
How do I use the rule of 72?
One of the most useful things about the rule of 72 is that it can tell you (with a high degree of accuracy) how long it will take to reach a financial goal. Retirement, college funding, home down payment, etc.
Say you would like to retire with $5,000,000, and you have $10,000 to invest, and your assumed rate of return is 10% per year. Simply run the numbers:
72 / 10 = 7.2 years to double.
More math:
$10,000 to $20,000 = 7.2 years
$20,000 to $40,000 = 7.2 years
$40,000 to $80,000 = 7.2 years
$80,000 tp $160,000 = 7.2 years
$160,000 to $320,000 = 7.2 years
$320,000 to $640,000 = 7.2 years
$640,000 to $1.2M = 7.2 years
$1.2M to $2.4M = 7.2 years
$2.4M to $4.8M = 7.2 years
Add the years together to reach a total of 64.8. Interesting.
Add $10,000 to a trust for a child when they are born, find an investment that returns on average 10% annually, and you'll leave them with a $5,000,000 retirement nest egg.
Also worth noting here is that 80% of the total wealth happened in the last two periods out of 9. This is how compounding works. You need time to get the most out of compounding.
Variables of the Rule of 72
The only two variables in the rule of 72 are the return on Investment number and the starting capital amount.. Tweaking the starting capital number in the formula is easy (not quite as easy as coming up with the money though!)
There are two ways to tweak the ROI number.
Increase returns
Decrease losses.
Of the two, decreasing losses is ultimately more effective. Increasing gains by 10% gives the same result as decreasing losses by 7.5%.
Increasing returns (by increasing gains or decreasing losses) by just 1% cuts the necessary time to get to the $5M above by a whopping 5 years. Imagine getting 5 years of your life back!
Increasing returns by 2% takes it down to only 54 years, or 10 years less than the first calculation.
At 14% ROI, it would take 46 years to get from $10,000 to $5M.
Invest $250,000 to start and at a 14% return, it would take just shy of 25 years to get to the $5M. The magic of compounding!
Can we help?
Our entire investment philosophy is to cut risk and grab the extra % for our clients. As seen above, a small decrease in risk can have dramatic results, especially when compounding is important (clients 10-15 years from retirement have the most to gain by cutting risk).
Give us a ring or set up an initial consultation with us for free, and we can go over your personal situation and see if our portfolio makes sense for you.