You could live to 120 and not know everything you could possibly know about investing. However, it's also important to have a firm grasp on the basics.
One of the most basic concepts of personal finance involves the rule of 72. Have you heard about it? If you have, have you actually used it? If not, you're missing out on a telltale sign of what's to come with the money you've currently saved.
Let's go over the rule of 72 and why you need to know about it. Here's a hint: It shows you compounding interest in action.
What is the Rule of 72?
Put simply, the rule of 72 is a formula that tells you how long it'll take for your investment to double in value and it's based on your rate of return.
The rule of 72 formula works well for lower rates of return, not higher rates of return. In fact, it works better in the ranges of 5% to 12% return.
What is the Rule of 72 Formula?
The formula looks like this:
72 / Rate of Return on Investment (Interest Rate) = Years to Double
Note that you should use the full number of your rate of return. For example, you don't want to use 0.08 in place of 8% — just use the number 8.
Here's an example of how you can use the formula. Let's say you plan to invest $10,000, and you're wondering how long it'll take you to double your money to $20,000. Your interest rate is currently 8%. The formula, 72/8 = 9.
In this case, it'll take 9 years for your money to double to $20,000. As you can see, the rule of 72 focuses on the interest rate, not the principal — though the more you invest initially, the more money you'll make once it doubles, of course!
You can also type in a Google search "rule of 72 calculator" if you have a more complicated interest rate, such as 5.45%.
Why You Should Use the Rule of 72
Why should you care about the Rule of 72?
Reason 1: You pay more attention to what will happen to your investments in the future.
It's important to know what's going on with your money, so why not project your future investment profit amount? For example, let's say you have a goal to save for retirement. You plan to retire in 20 years, and you're wondering how long it will take you to get the $500,000 you've already invested to $1 million. (This kind of calculation is really fun!)
Let's say you've invested fairly conservatively and your interest rate hovers around 4%.
72/4 = 18
You'll double your investment from $500,000 to $1,000,000 in 18 years. If you're going to retire in 20 years, the rule of 72 says you'll make it with two years to spare.
Now, it's easy to poke holes in this calculation. Remember that it's just an estimate because the calculation assumes that the rate of return is fixed, not volatile, but the reality is that the market moves.
Reason 2: You can use it to figure out your risk tolerance.
Really, why do you need a better reason than that? I'm sure, like me, you like to hit the easy button when it comes to figuring out investments.
How would you use it to figure out your risk tolerance?
You might want to invest less conservatively if you know it's going to take you longer to reach your investment goals.
For example, let's say you're toying with the idea of investing $10,000 in a combination of stocks and bonds that will yield about 5%.
You can use the rule of 72 formula to estimate how long it'll take to double if you never contribute any more money to it. Compound interest growth from the rule of 72 formula says that it will take 14.4 years to double to $20,000 because 72/5 = 14.4.
Now, let's say you think that's too long. You want to speed up the process, so you consider investing in an all-stock portfolio that has the potential to earn more in returns. You may consider how $10,000 will double with an 8% return instead. In this case, you'll cut your time by five years! It looks like this: 72/8 = 9 years.
Reason 3: It's a simple calculation.
Why not tackle the obvious? The rule of 72 offers a simple calculation that can give you a general idea of what you're looking for.
It's important to remember a few things, however:
It doesn't offer precise calculations: Again, the rule doesn’t work with higher rates of return. You may want to use exact mathematical calculations or a good investment calculator online if you really want to know exactly what you'll get out of your investment in the future.
Understand its purpose: Does the rule of 72 intend to pinpoint your exact potential? No. Offering precise calculations isn't its real intention. You should use it as a general guide.
Watch overaggressive investing: The rule of 72 might encourage you to invest inappropriately for your situation. If you think you should invest more conservatively but the rule of 72 tips you toward thinking you should invest more aggressively, keep in mind that you have a higher chance of losing money in a downturn with a more aggressive portfolio. If you need the money sooner rather than later, you might face the negative consequences of taking the wrong investing approach for your situation.
Use the Rule of 72 Judiciously
You always want to use good sense when you apply any formula and consider it an "absolute." Lots of factors come into play, such as the fact that you can never pin down a variable interest rate when using the rule of 72. However, the rule of 72 still offers one of the most effective predictors of how much an investment will change over time.