The Rule of 72
As a Certified Financial Planner™ one of my main goals is to help clients make sense of the financial world. I find that when they understand finances they make the best decisions wherever their life and money intersect so we can then put together a plan so their life unfolds the way they want it to. In that spirit I wrote this blog post.
One of the most important things people can understand about finances is interest. As they say those that understand interest earn it, and those that don’t pay it. Fortunately there is a really simple math trick called the Rule of 72 that can help us understand how interest can impact our finances from both an investment and debt perspective. Below is a brief explanation of the rule.
The RULE OF 72
The Rule of 72 is a simple way to determine how long an investment will take to double given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors obtain a rough estimate of how many years it will take for the initial investment to double. For example the Rule of 72 states that $1000 dollars invested at an annual fixed interest rate of 10% would take 7.2 years to grow to $2000 (72/10=7.2). In reality a 10% investment will take 7.3 years to double (1.10^7.3=2) but the rule of 72 is reasonably accurate for rates of return below 20%.
WHY IT IS SO IMPORTANT
The Rule of 72 is a powerful means for anyone that can do simple division to understand interest which is integral to understand finances. Let’s go through a few examples that can show why it’s so helpful.
INFLATION
Lets look at inflation for instance. Inflation is simply the slight increase in prices of goods and services over time. Gas, Milk, chocolate bars, etc have all increased in prices since we were kids. Over the last 50 years the average annual price increases on goods and services was 3.22%. At that rate we know that prices will double every 20 years. We now understand that we need to have an investment that at the very least keeps up with inflation.
* https://inflationdata.com/Inflation/Inflation_Rate/Long_Term_Inflation.asp
CASH ISN’T KING
People like having cash in the bank as one has immediate access (i.e. liquidity) and it doesn’t go down in value (protection of principle). But that comes at a price. The national average that banks pay on our deposits is only 0.25%! The Rule of 72 shows us that it would take 288 years for our money to double at that rate. Clearly you may not want a significant amount of your investments in cash because it can’t keep up with the general increase in prices (inflation).
CREDIT CARD DEBT IS CRAZY
The average credit card interest rate is 15.09%/year. At that rate account balances will double every 4.5 years. For example, $1000 owed becomes $2000 owed in just 4.5 years, and $8000 owed in just 9 years. We need to avoid credit card debt at all costs, literally.
* https://wallethub.com/edu/cc/average-credit-card-interest-rate/50841/
STOCKS VS BONDS
Since 1926, large stocks have returned an average of 10% per year; long-term government bonds have returned between 5% and 6%, according to investment researcher Morningstar. With The Rule of 72 you can see why it’s important that you may want to ensure you incorporate stocks and bonds as part of your investment portfolio, and that for longer term investments (10 years or greater), you may want to include a high proportion of stocks.
*https://money.cnn.com/retirement/guide/investing_bonds.moneymag/index3.htm
FINAL WORD
As you can see a simple formula can help us better understand our finances so when our respective lives intersect with money we can use the Rule of 72 to make a choice that benefits our long term goals so life turns out the way we hope it will.
If you have any questions about the Rule of 72 or if you are making the best choices where life and money intersect, please feel free to reach out and we can schedule a time to review your plans.
This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing. Investing involves risk including loss of principal. No strategy assures success or protects against loss. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. The rule of 72 is a mathematical concept and does not guarantee investment results nor functions as a predictor of how an investment will perform. It is an approximation of the impact of a targeted rate of return. Investments are subject to fluctuating returns and there is no assurance that any investment will double in value.
