Thursday, June 28, 2012

The Rule of 72

The Rule of 72 is a mental shortcut to estimate the effect of compound interest. Simply, by dividing 72 by an interest rate, you can estimate how long it will take for funds to double. In formula form:

Years to Double = 72 / Interest Rate

For example, if an investor currently has their nest egg invested in certificates of deposit (CDs) yielding 2%, it will take that individual 36 years (72 / 2) to double their retirement account. By comparison, if the person invested in a diversified portfolio earning 8% over time, their funds would double in 9 years (72 / 8).

The Rule of 72 is useful for understanding the importance of maximizing returns over time. For instance, if a 42-year old hoping to retire in 24 years at age 66 obtained a 6% annual return over this time span, funds would double twice (72/6 = 12 years to double; 24 years until retirement / 12 years = 2). Thus, a $100,000 investment now would be worth $200,000 in 12 years, and $400,000 by the time she retired. Alternatively, if the investor was able to achieve an annual return of 9%, funds would double three times (72/9 = 8 years to double; 24 years until retirement / 8 years = 3).  This investor’s $100,000 investment would be worth $200,000 in 8 years, $400,000 in 16 years, and $800,000 at retirement.  In this case, an increase in return from 6% to 9% allowed the investor to double their nest egg by retirement.

The Rule of 72 can be applied to anything that increases in value:
  •  Inflation – If inflation averages 3%, your money will lose half its value in 24 years (72 / 3).
  •  Long-Term Care – If the cost of long-term care increases by 4%, it will be twice as expensive in 18 years (72/4).
  •  Debt – If your credit card charges 24% interest, you will owe twice as much in 3 years!
  • Economic Growth – If America’s gross domestic product grows by 3% per year, the size of our economy will double in 24 years.

Compound interest is powerful; make sure it works for you and not against you!

1 comment:

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