The Rule of 72 is a formula used in investing that helps investors estimate how many years it takes to double the value of your investments.
The formula for the Rule of 72 is simply 72 divided by our annual rate of return.
Why is this helpful?
The reason the Rule of 72 is so helpful in investing is that it helps determine how long it would take to double money based on a annual rate of return and also can help illustrate the power of compounding. Investments do not grow in a straight line. Instead, they compound, which means they grow exponentially. This is because returns happen on both principal and accumulated interest.
An easy example
To better understand this concept, look at the example below.
Let us first assume that an investor, who we will call Lucia, invests in stocks and will earn a 10% rate of return per year. Knowing that and the Rule of 72 allows us to determine that she will have approximately twice as much money as she does today in 7.2 years. We know this because we calculate 72/10 = 7.2 years.
Now lets compare how long it takes Tiffany to double her money as she earns a bit more each year because she works with an investment advisor. Her advisor helps her invest in the stocks of good businesses, encourages her to keep a long term perspective, and makes it easy for her to contribute regularly to her investment account. Because she does these things, she earns a bit more than Lucia and over time makes a 15% return per year. In this example, Tiffany would only take 4.8 years to double her money. We know this from our calculation 72/15 = 4.8.
That’s much faster than Lucia!
Despite that, both Lucia and Tiffany benefit by investing in stocks and bonds instead of putting all their money into a savings account. This is because in a savings account, money earns very low returns. In fact, as of August 2021, the average returns earned in savings accounts in the United States was only 0.06%.
Assuming that instead of investing in stocks or bonds, Tiffany and Lucia simply put their money into savings accounts that earn the average return of 0.06% per year. The Rule of 72 tells us that it would take Tiffany and Lucia approximately 1200 years to double their money.
That does not sound like a great way to achieve their financial goals.
The Rule of 72 is a very useful tool for investors to determine how long it will take to double their money assuming an annual rate of return. It also helps explain compounding and puts into context why you should be investing at least a portion of your hard-earned dollars in stocks and bonds rather than a savings account.
To get started making your money work for you like Tiffany and Lucia, open an account today.
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