Saturday , 1 October 2016


The Rule Of 72 Can Help You Reach Financial Goals – Here’s Why & How

Interest-RatesCompounding can be tricky to calculate in your head, however, unless you’re a math whiz. The good news is you can use a mathematical shortcut called the “rule of 72” to quickly estimate how long it takes an investment with a fixed annual return to double in size.

The article below is an enhanced version (i.e. not a duplicate) of the original from MotifInvesting.com as it has been edited ([ ]) and abridged (…) by munKNEE.com to provide a faster and easier read. Enjoy!

The Perks of Compounding

First, it is important to grasp the concept of compounding. In essence, compounding refers to generating earnings from previous earnings. As an investment grows, the rate of return is calculated on a larger base. The opposite occurs if an investment is in decline.

For example, let’s say you invest $10,000 in a stock that rises in price by 10% in year one. In other words, your $10,000 grows to $11,000 at the end of the first year. Happy with a $1,000 gain, you decide to keep the investment. The stock rises another 10% in year two. At the end of the second year your total investment is now worth $12,100. Even though the stock rises 10% in both years, your investment appreciates an additional $100 in year two. Why? Your year two returns are calculated on a larger base, $11,000 versus $10,000.

Compounding can be tricky to calculate in your head, however, unless you’re a math whiz. The good news is you can use a mathematical shortcut called the “rule of 72” to quickly estimate how long it takes an investment with a fixed annual return to double in size.

Rule of 72: divide the number 72 by the annual rate of return you expect on an investment. The result is the approximate number of years it takes to double your money.

Now let’s see why it can take 10 years to double your money in stocks versus 72 years in a savings account. If you invest $10,000 and earn a respectable 7% a year, it takes about 10 years to get to $20,000.

72 / 7 = 10.28 years

Savings accounts and CDs, on the other hand, still earn close to bupkis these days. A savings account offered by a national bank currently yields 0.75% while a 12-month CD yields 1.05% Depositing $10,000 with, say, a 1% rate of return – which is below the Fed’s target rate of 2% inflation – takes about 72 years to double. Wow, that’s a mighty long time compared to 10 years for stocks to double!

72 / 1 = 72 years

Of course the stock market does not provide a fixed rate of return every year. Use the rule of 72 for ballpark estimates. Your actual results can vary but historically stocks have been a more efficient way to grow wealth.

See how $5,000 can grow over time under investments with different rates of return. The Rule of 72 illustrates that it’s best to start investing early. If you can take the risk and put into vehicles with higher expected rate of return, the faster your money will multiply. Source: World Financial Group, Inc.
See how $5,000 can grow over time under investments with different rates of return. The Rule of 72 illustrates that it’s best to start investing early. If you can take the risk and put into vehicles with higher expected rate of return, the faster your money will multiply. Source: World Financial Group, Inc.

Estimate Large Expenses With the Rule of 72

To help you plan for your future expenses, you can also use the rule of 72 to estimate them. Let’s say you welcome a baby into your clan. How much is her college education going to cost?

First, research shows the projected annual increase in college tuition and fees is 3-4%. Now use the rule of 72 to estimate how long it may take for tuition costs to double.

At an annual cost increase of 3%, tuition costs can double in 24 years.

72 / 3 = 24 years

If prices go up 4% a year, however, tuition can double in 18 years.

72 / 4 = 18 years

Let’s assume a 4% annual cost increase in our example since a baby born today should be ready to enter college 18 years from now.

Second, let’s examine the cost of college today. According to The College Board, in-state costs average $9,410 for tuition and fees, and $10,138 for room and board totaling $19,548 for 2015-16. Private, not-for-profit schools average $32,405 for tuition and fees, and $11,516 for room and board totaling $43,921. Public school expenses for out-of-state students fall in between.

Let’s use an initial cost of $32,000 per year. Applying a subsequent 4% increase in cost each year results in an approximate cost of $135,886 for a student entering a 4-year college today.

Year 1: $32,000
Year 2: $33,280
Year 3: $34,611
Year 4: $35,995

Total: $135,886

Lastly, double the above total to get a rough idea of how much your baby’s college education expenses will be in 18 years: $271,772. That’s quite a difference!

The Rule Of 72 Can Help You Reach Financial Goals

Once you estimate how much money you may need for the big expenses down the road, work on an investment plan to pay for them.

For example, let’s say you find an investment earning 12% a year. If you invest about $34,000 today, your bundle of joy will have an ample college fund by the time she’s 18. What’s the math? The rule of 72 says you can double your money in six years with a 12% annual return. Work backwards from $272,000 and then halve your money for each six-year period. This means you would need about $136,000 saved by year 12, $68,000 by year six and $34,000 today. Nifty!

There are many other ways to use the rule of 72 as well. You can estimate how long it can take your home’s value to double. Or you can use the rule of 72 to calculate the potential impact of inflation on your savings. At a 2% annual rate of inflation, assuming your cash is not earning any interest, your savings can halve in about 36 years. A 3% rate of inflation halves your money in 24 years, a 4% rate at 18 years, etc.

The Rule Of 72’s Imperfections

It’s important to remember that most investments do not provide fixed rates of returns. In addition, the rule of 72 does not account for investment fees or capital gains taxes. It’s also helpful to note that rates of return between the range of 6% and 10% work best with the rule of 72. Curious math geeks seeking further information can read Stanford’s complex explanation on the numbers.

The differences between the rule of 72’s estimates and the actual time it takes to double your money based on a fixed annual rate of return vary by rate.
The differences between the rule of 72’s estimates and the actual time it takes to double your money based on a fixed annual rate of return vary by rate.

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