The Rule of 72 is a great mental short cut that allows us to estimate the effect of any Expected Rate of Return (ERR) required to double an investment, estimate the time period it would take to double an investment, and approximate the impact of inflation on future dollars or the impact of a rising lifestyle expense.
Here is how it works…. To determine how long it would take to double your investment, divide 72 by your expected rate of return. Assume your ERR is 6% (72 divided by 6 = 12 years). Your investment would take approximately 12 years to double.
Formula: 72 ÷ ERR = Years Until Doubled
4% ERR: 72 ÷ 4 = 24 Years
12% ERR: 72 ÷ 12 = 6 Years
What if you needed to double your money in 5 years in order to meet a specific funding goal? 72 ÷ 5 years = an ERR of 14.4%. Wow! That might be a tough return in this market! How about doubling my funds in 8 years?
Formula: 72 ÷ # of Years = Required ERR
8 Years: 72 ÷ 8 = 9%
10 Years: 72 ÷ 10 = 7.2%
The Rule of 72 also works on an inverse basis. Assume that you receive a fixed annuity payment of $400. What if you wanted to estimate the impact of 3% inflation, or purchasing power, on your current payment? 72 ÷ 3 = 24 years. What this means is that in 24 years your fixed annuity payment, which has not risen with inflation, will be worth half of what it is worth today. While you will still receive $400, in 24 years that $400 would only buy $200 worth of goods in today’s dollars. This may explain why your Advisor is so concerned about making sure your investment resources maintain some aspect for growth.
The formula also works well for estimating the future cost of goals such as education. Assume the average cost of higher education tuition today is $12,000. When will this figure double? Tuition is expected to grow on average 5% annually. Assume your child is currently 4 years old. 72/5= 14.4 years. Therefore you can expect that tuition for your 18 year old college freshman will be in the neighborhood of $24,000 per year. (Look out for higher increases in Fees, Books, Room and Board. They are not as scrutinized as Tuition and also do not qualify, for the most part, for gifting).
The Rule of 114. Want to know how long it would take to triple your investments? Divide your ERR into 114. Given an ERR of 7%, it would take approximately 16.3 years to triple your investment, 114 ÷ 7 = 16.3. If I had an opportunity to earn a 6% ERR, it would take me 19 years to triple my investment.
The Rule of 144. How about a rule of thumb to estimate how long it would take to quadruple your investment? Divide your ERR into 144. Given an ERR of 7%, it would take approximately 20.6 years to quadruple your investment, 144 ÷ 7 = 20.57 years.
Compound interest is a very powerful tool, sometimes jokingly referred to as the eighth wonder of the world. The Rule of 72 is a guideline that provides with the ability to project the impact of compounding; the results are not exact…but close. Generally, the higher the ERR is the more inaccurate the rule, but not by much. Mathematically, the rule of 69.3 is actually the most accurate, but not as divisible as 72, and therefore not as popular. Same goes for the Rule of 114 and 144.