When planning for retirement, people often wonder how they can assess the growth potential of their investments in a simple, straightforward way. Enter the Rule of 72, a tool that has stood the test of time in the realm of wealth management. It’s a very simple rule, yet its applications are profound. But is it the right tool for you? In this blog post, we’ll delve into the Rule of 72 and explore whether it aligns with your financial goals and investment strategy.
We’ll discuss how this rule works, its merits, and its limitations, so you can make an informed decision about whether to incorporate it into your financial planning toolkit. As financial planners, our goal is to empower you with the knowledge and strategies that best suit your unique financial journey. By the end of this post, you’ll have a clearer understanding of whether the Rule of 72 is a valuable asset on your path to financial success.
What is the Rule of 72?
The Rule of 72 is a simple and quick way to estimate how long it will take for an investment to double in value at a fixed annual rate of return. It’s a useful tool in wealth management and financial planning to help individuals understand the potential growth of their investments over time. Here’s how it works:
Number of years to double = 72 / Annual Rate of Return.
Let’s say you have an investment with an annual rate of return of 8%. Using the Rule of 72, you can estimate that it will take approximately nine years for your investment to double (72 / 8 = 9.)
The Rule of 72 uses the number 72 because it’s a convenient approximation that makes mental calculations relatively easy. The choice of 72 is historically based on the number 72 having many small divisors, which makes it useful for this purpose.
When you divide 72 by various common interest rates (expressed as percentages), the resulting numbers provide a relatively accurate estimate of the number of years it takes for an investment to double. For example:
- At a 1% annual rate of return, it takes approximately 72 years for an investment to double (72 / 1 = 72.)
- At a 2% rate of return, it takes approximately 36 years (72 / 2 = 36.)
- At an 8% rate of return, it takes around 9 years (72 / 8 = 9.)
While 72 is a simplification and approximation, it’s close enough for many practical purposes and provides a quick mental tool for estimating the effects of compounding interest. It’s important to note that the Rule of 72 works best for interest rates in the range of 5% to 10%. For interest rates significantly outside this range, the approximation becomes less accurate, and other rules like the Rule of 70 (see below) or more precise financial calculations should be used.
Pros and Cons of the Rule of 72
Some of the benefits of this rule include:
- Simplicity: The Rule of 72 is very easy to use and doesn’t require complex calculations or financial software.
- Quick estimates: It provides a rough estimate of how long it will take for your money to double, allowing you to make quick, back-of-the-envelope calculations.
- Helpful for financial planning: It can help individuals set realistic investment goals and understand the power of compounding.
Some downsides of the Rule of 72 are:
- Approximate: The Rule of 72 is an approximation and may not be completely accurate, especially for very high or very low rates of return. It becomes less accurate as the rate of return deviates from the assumed annual growth rate.
- Ignores other factors: It does not take into account factors like taxes, fees, inflation, or market volatility, which can significantly impact the actual growth of an investment.
- Limited to doubling: The Rule of 72 is primarily useful for estimating how long it takes for an investment to double. It doesn’t provide information about the overall growth trajectory or how an investment will perform beyond that point.
What Are Alternatives to the Rule of 72?
There are several alternatives and variations to the Rule of 72 that can be used to estimate the time it takes for an investment to double or for money to grow at a fixed rate. Some of these alternatives include:
- Rule of 70: This is similar to the Rule of 72 but uses the number 70 instead of 72 in the formula. It works the same way, providing an estimate of the time required to double an investment at a fixed annual rate of return.
- Number of years to double = 70 / Annual Rate of Return
- Rule of 114: The Rule of 114 is an extension of the Rule of 72 and is used to estimate how long it takes for an investment to triple in value.
- Number of years to triple = 114 / Annual Rate of Return
- Rule of 115: Similar to the Rule of 114, the Rule of 115 is used to estimate the time it takes for an investment to quadruple in value.
- Number of years to quadruple = 115 / Annual Rate of Return
- Rule of 144: The Rule of 144 is used to estimate how long it takes for an investment to grow by a factor of 10.
- Number of years to grow by a factor of 10 = 144 / Annual Rate of Return
- Rule of 69.3: This rule is often used when the rate of return is expressed as a continuously compounded rate. It provides a more accurate estimate for continuous compounding.
- Number of years to double = 69.3 / Annual Rate of Return
- Online Calculators: There are numerous online financial calculators and spreadsheet software programs that can perform precise calculations for investment growth, considering factors like compounding intervals, taxes, and fees.
While these alternatives provide more specific estimates than the Rule of 72, they are still approximations and may not account for all factors affecting investment growth. Therefore, when making important financial decisions, it’s advisable to use more comprehensive financial planning tools and consult with a financial advisor for a complete understanding of your investment strategy.