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Every investor needs dependable estimates on how much their investments will grow in the future. Professionals take advantage of complicated models to answer this question, but the rule of 72 is a tool that anyone can use.
What Is the Rule of 72?
The rule of 72 is a simple way to estimate the number of years it takes an investment to double in value at a given annual rate of return. It’s calculated by dividing the number 72 by the annual rate of return.
For example, if an investment has an 8% annual rate of return, it would take approximately nine years for it to double in value (72 / 8 = 9).
Investors, business owners and financial planners can use the rule of 72 to project return on investment (ROI) for different strategies. The rule can also be used to estimate the impact of inflation on investments. It can also tell you the annual rate of return offered by an investment given how many years it will take to double in value.
The Rule of 72 can be used for any asset that grows at a compounded rate. Compounding returns is a powerful force when it comes to saving and investing, since interest is calculated both on the initial principal plus accumulated interest from previous periods.
How to Calculate the Rule of 72
Calculating the rule of 72 is easy: Simply divide the number 72 by the annual return of the asset in question.
72 / annual rate of return = years needed to double your investment
Let’s apply the rule to a mutual fund investment. Say you invest $50,000 in a fund that you expect to generate a return of 6% a year, based on the fund’s average annual return over the last decade.
72 / 6 = 12
The rule of 72 suggests that your mutual fund investment would double to $100,000 in 12 years.
The key assumption of the rule—that the rate of return remains stable for years—means that it only offers a very approximate estimate. Past performance is no guarantee of future results, and who’s to say that you’ll enjoy that 6% annual return every year?
Given ever-changing market conditions, inflation rates and economic performance, actual returns tend to vary considerably year to year. However, the rule can be very useful in helping to inform your return objectives and investment strategy as long as you remember that it’s only a tool for making very broad estimates.
How Accurate Is the Rule of 72?
The Rule of 72 has been used for a long time. The first reference to the rule appeared from 15th century Italian mathematician Luca Pacioli in his work Summa de arithmetica. He discusses the rule in reference to the doubling time of investments, but does not explain the derivation, leading many to believe that he was building on the work of an earlier scholar.
A headache-inducing derivation is beyond the scope of this article, but if it were to be done, it would actually yield the Rule of 69.3. Since that isn’t a very easily divisible number, 72 works a little better. Some suggest that 69 is more accurate when used for continuous compounding.
For rates of return that range from 6% to 10%, 72 is the optimal number to use. If you’re looking at potential returns of less than 8%, a good rule of thumb is to subtract 1 from 72 for every 3 points lower than 8%.
Therefore, at a rate of return of 5%, the Rule of 72 becomes the Rule of 71. At rates higher than 8%, add 1 for every 3 percentage points. With a projected rate of return of 11%, you use the Rule of 73.
How to Use the Rule of 72
In addition to being a useful estimation tool that can help formulate investment objectives, the Rule of 72 is also a helpful method for comparing investments.
For example, if one investment has a projected return of 8% and another has a projected yield of 10%, you can see how much more quickly you’ll double your money at the higher rate.
However, the Rule doesn’t only apply to appreciation. You can use the rule to find out how inflation will impact your investments. Assume that inflation is 8%. Dividing 72 by the inflation rate yields the information that your money will lose half of its purchasing power in nine years.
You can also apply the Rule of 72 to debt for a sobering look at the impact of carrying a credit card balance. Assume a credit card balance of $10,000 at an interest rate of 17%. If you don’t pay down the balance, the debt will double to $20,000 in approximately 4 years and 3 months. There’s a sobering fact.
The Final Word on the Rule of 72
The rule of 72 offers an important benefit to new investors: It illustrates very clearly the power of compounding in building long-term wealth. However, it’s best used to make quick, back-of-the-envelope estimates. It is no substitute for thorough research coupled with a well-thought-out financial plan.
Before investing, it’s always prudent to carry out thorough due diligence to understand the potential risks of any investment and how these risks impact estimated returns. Fees, taxes and other costs can also figure into the mix.
Consider working with a financial advisor to develop a plan to meet your long-term financial goals.
