How To Make Money and Build Wealth Using the Rule of 72
How would you like to be able to mentally calculate how long it will take to double your money? And, I am not referring to the casino betting system where an out-of-luck gambler is hoping to get his money back by doubling down.
The Rule of 72 is a system that allows you to easily calculate how long it will take to double your investments based on a fixed rate of return. Conversely, it can also help you calculate what rate of return you need to achieve if you are going to double your money.
Come along as we explore this rule that makes it easy-peasy for non-mathematicians to become instant geniuses in calculating compound interest and how it impacts their investment portfolio.
The Rule of 72 and your Investment Portfolio
The Rule of 72 is a simple formula to calculate how long it will take for your money to double. For example, say you have $50,000 in a portfolio of stocks that has an 8% rate of return. How many years would it take to double your investment portfolio to $100,000?
If we are to carry out this calculation using traditional mathematics, it would take us a while. However, with the rule of 72, a few seconds is all we need. See how below.
Years to double your money (T) = 72 / Interest rate (R)
T = 72 / 8% = 9 years
It would take you 9 years to double your money to $100,000 if your rate of return (interest rate) is 8%. Expanding on this example, this is how long it will take to double your money given different interest rates:
The Rule of 72
|Interest Rate||Years to Double Investment|
We can reverse the Rule of 72 formula to solve for interest rates instead:
Interest Rate (R) = 72/Years to double your money (T)
So, for example, if you want to double your $50,000 portfolio in 6 years, using the formula, you will need to put your money in an investment that earns at least 12% per year.
The Rule of 72 Reversed
|Years to double investment||Interest Rate|
Related: 115 Smart Ways To Save Money
The Power of Compounding Interest and Risk vs. Return
What the Rule of 72 shows us is the magic of compounding interest rates over time vs. simple interest over the same period. It is no wonder that Albert Einstein referred to compound interest as “the most powerful force in the universe.” The examples above show that even without making additional investments, your funds can grow to $100,000 in 9 years if you invest in a realistic investment portfolio that earns 8% year-on-year.
The rule makes it easy to make mental estimates of financial parameters without getting into lots of mathematical mumbo-jumbo. In addition, it also highlights the subject of risk vs. return. The higher the risk of your portfolio, the higher the potential expected returns.
For example, if you choose to put your $50,000 in a bucket of Treasury Bills (or a savings account) that pays 2%, it will take you 36 years to double your otherwise ‘safe’ investment.
On the other hand, you may be able to double your funds in 6 years if you socked it into a stock portfolio that is significantly riskier or more volatile. The price of safety is a much longer period to increase your wealth.
Compounding Interest and Debt
Compound interest is a double-edged sword. If you carry credit card debt, compounding interest could make it nearly impossible for you to become debt-free if you are only making minimum payments.
For example, if you have a credit card balance of $10,000 at 21% and make minimum payments of $250 every month, it will take you 70 months (5 years and 10 months) to pay off the balance. During this period, you will also pay $7,350 in interest!
The reason for this exorbitant amount in interest payments (73.5% of your original principal) is that your debt balance keeps on increasing even while you are trying to pay it off because the interest cost continues to compound.
If you increased your monthly payments by 30% to $325 ($15 extra added to the minimum payment), you become debt-free within 45 months and save about $3,000 in interest fees.
Variations of the Rule of 72 and Caveats
The Rule of 72 is simple and practical, but it is not perfect. Consider the results you get using it only as an approximation of reality. For example, the rule is more accurate when your expected rate of return is between 6% and 10%, and the sweet spot is an 8% interest rate.
Mathematically, the Rule of 72 works out to be 69.3. However, this number is ignored because:
- No one wants to do mental math with a numerator that is 69.3
- The Rule of 69.3 doesn’t sound right or sexy. Or, does it? Sometimes, it is rounded off to ’70’ for the Rule of 70.
Variations of the Rule of 72 generally suggest that you could adjust 72 by a value of ‘1’ for every 3 percentage points from 8% (+ or -). So, for example, if your expected rate of return is:
- 8%: use the Rule of 72
- 5%: Use the Rule of 71
- 11%: Use the Rule of 73
- 14%: Use the Rule of 74, and so on for better accuracy.
If the precision of the numbers is important to you, you can just stick to using 69.3 for all your compound rates that are 10% or below.
Is the Rule of 72 accurate? 72 is an easier mental shortcut and is accurate enough if all you need is an estimate of how long it will take to double your money.
Here’s a chart from Investopedia that shows how close the Rule of 72 is to being accurate as rates change:
Here’s a Rule of 72 calculator if you’d rather use one.
Some other things to note when using the Rule of 72 is that it does not factor in:
Higher investment returns often go alongside with higher risk. Your financial situation (e.g. if you need regular income in retirement) may not be compatible with assuming higher investment risks.
Financial advisors tell you that returns are not guaranteed for good reason. While the long term average return of the stock markets may be closer to 10%, there are years when market returns fall or rise significantly e.g. the -30% or worse experienced during the financial recession of 2008. Your expected return may fluctuate widely in reality.
Investment Fees and Taxes
Fees and taxes cut into your portfolio earnings and can impact how long it takes to double your money. This is why it’s important to minimize your investment fees such as by:
- Utilizing robo-advisors like Wealthsimple (get a $50 bonus or invest up to $10,000 FREE) who charge a low management fee and use low-cost ETFs to build your portfolio
- Investing using lower-cost index funds
- DIY investing
Overall, the Rule of 72 is a useful formula to estimate your investment horizon if you plan to double your money. More importantly, use compound interest to your advantage by investing early and often so you can watch your account grow over time.
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