The Rule of 72 is a handy bit of mental math to discover how long it would take to double - or halve - a sum of money
If you wanted to know how long it would take before you doubled your money in an investment or retirement savings account, it might prove difficult. Where would you even begin to try figure this out, and why should it even matter?
I will get to the why shortly, but figuring out how long it will take is actually very easy.
You don’t have to make it very complicated by having to input a bunch of numbers into an excel spreadsheet. One website I looked at gave me a formula that looked something like this = (LN(2)/(LN(1+A2/100)))
The answer can be arrived at much easier by referring to what’s known in the financial world as the Rule of 72. This is a very simple and valuable mental math shortcut that will show you how long it will take a sum of money to double or halve if you’re going the other way.
What you do is take the number 72 and divide it by your interest rate.
If, for example you are earning 3%, you simply divide 72 by 3 and the answer is 24.
So if you have invested €20,000 into an account or fund that returns 3% every year, in 24 years the balance in your account will be €40,000.
You can also use the rule of 72 to find out what rate of interest you need if you wanted to double your money within a specific time period.
For example if you wanted your money to double every 10 years, take 72 and divide it by 10, and you get 7.2. That is the rate of interest you need to earn every year. So, why is this rule useful to know?
One reason it helps is identifying what type of account you need to invest in, and what risk to your capital you are willing to take.
For example, if you wanted to have your capital 100% guaranteed and thus the interest your savings was earning was 1%, then your money would double in value in 72 years’ time. Maybe your capital is more important to you than seeing your savings double in value and if that’s the case, then fine.
But if you don’t want to wait 72 years, and want your capital to double every decade then you need to be earning 7.2% per year. That means you need to invest in accounts that carry an element of risk and, in all likelihood, are exposed to stocks and shares.
The rule of 72 is a useful way of translating something we don’t really know how to connect with i.e. interest rates and return on investments, into something we can relate more to and that is time and how long it takes for our money to double or halve in value e.g the impact inflation can have on our money.
For this reason, I use this rule when I talk to groups about pension planning because it is much more effective than talking about different types of low and high risk funds or what interest rate you are getting each year. Both are very important and linked, but the rule of 72 I believe makes much more sense of them.
For example if I was to ask you whether you thought the difference between 5% or 7% was a big deal, you mightn’t know the answer and because there is only a 2% difference, you think your’re not losing out much.
But think again, because what if I was able to tell you very quickly that 2% when put into a compounding formula makes a huge difference on how quickly your money grows.
Let me explain. The rule of 72 tells us that a return of 7% means your money will double in 10.3 years’ time. And a 5% return means your investment doubles every 14.4 years.
If you are 30 and earn 7% per year, you will double your money every 10 years instead of every 14 years and that will make a huge difference in how much money you have at age 60.
Investing and achieving an annual return of 7% has the opportunity to have three doubles – it will double three times, once per decade.
The person who is investing at 5% on the other hand has the same 30 years of investing but only has the possibility of doubling their money 2.08 times.
If you think about this, say you have €50,000 today, doubled three times will leave you with €400,000 at 60 after the third doubling.
But if it doubled 2.08 times and let’s round that down to two, at 60 you will have €200,000.
So, the difference of 2% over that length of time is €200,000 and that seems a much bigger and more real difference than little ole 2%.
That’s why when it comes to investing and selecting the right account and fund to invest in, everything matters, particularly when it comes to your pension account. Investing in a fund that has a high weighting in equities and therefore a higher probability of achieving higher returns (high risk) something moving towards 7% or 8% or 9% per annum is something you should be doing particularly when you are young enough to take that risk, rather than investing in cash or bonds (low risk but very low return) because your return will be much smaller.
So, if you are wondering how long it will take for debt or an investment to double in value, just divide the number 72 by the interest rate and that is your answer. You will now be able to create an accurate, easy to calculate and meaningful way of interpreting debt, expenses and interest rates and how they can impact your finances, good and bad and what decisions you make, can be aided by knowing the rule of 72.
Liam Croke is MD of Harmonics Financial Ltd,
based in Plassey. He can be contacted at email@example.com or www.harmonics.ie