You've likely heard of the "Rule of 72." It's a back-of-the-envelope metric for calculating how quickly an investment will double in value.
Most financial metrics are a little too complex to be done in your head. You're going to need a spreadsheet or a financial calculator to calculate the internal rate of return, yield to maturity, or common risk metrics like beta or standard deviation. The beauty of the Rule of 72 is that it can be calculated by the average nine-year old.
Let's take a look at what the Rule of 72 is, how it works and how you can use it in your financial planning.
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What is the Rule of 72 in simple terms?
The Rule of 72 is a straightforward formula that provides a quick-and-dirty approximation of the time it takes for an investment to double in value assuming a fixed annual rate of return. It's a solid tool for estimating the effects of compound interest and can be used to gauge the potential growth of your investments over time.
The formula for the Rule of 72 is ridiculously simple. You divide 72 by the annual rate of return you expect to earn on that investment. For example, if you expect an annual return of 8%, it would take approximately 9 years for your investment to double (72 divided by 8 equals 9).
What are specific examples of the Rule of 72?
Getting more concrete, let's say you own an S&P 500 index fund and you want to map out a few scenarios. If the index rises at its historical average of around 10%, you'd double your money in about 7.2 years (72/10 = 7.2). If you believed that the S&P 500 is more likely to return, say, 15% due to strong earnings, you'd double your money in 4.8 years (72/15 = 4.8). And if you believed the S&P would return a more mundane 5% due to, say, a recession, you'd double your money in 14.4 years (72/5 = 14.4).
The Rule of 72 can also be used to assess the impact of inflation on your purchasing power. If you want to determine how long it will take for the purchasing power of your money to be cut in half due to inflation, you can use the same formula. Let's say the inflation rate is 3%. You could divide 72 by 3 to get 24 years. Assuming a 3% rate of inflation, your purchasing power would be cut in half in 24 years.
Why should I use the Rule of 72?
The benefits of the Rule of 72 are obvious. It's a simple formula that anyone with elementary school math skills can calculate. It doesn't require a Wharton MBA or a CFA Charter. It also allows you to set realistic expectations for your investments and can help you determine whether your financial goals are achievable within your investment time frame.
You can also use the Rule of 72 to compare different investment options. For instance, if you're deciding between a stock fund and a bond fund with two very different expected returns, the Rule of 72 can help you assess which one gets you to your financial goal faster.
Remember though, the Rule of 72 is designed to be a rough estimate and its assumptions aren't always realistic. It assumes a constant rate of return, and stock returns are anything but constant. The average return is far from indicative of the return you're likely to get in any given year. It also doesn't account for taxes, fees or other expenses that can chip away at your returns. And like all financial models, it's only as good as its inputs: Garbage in, garbage out.
While by no means a comprehensive analysis, the Rule of 72 is a useful tool that provides a quick and easy way to estimate the time it takes for an investment to potentially double. It's valuable in financial planning and in comparing investment alternatives. And again, it's something that even a novice investor can put to work.
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