Power of 72
How to double your investment
While there are no guarantees in investing, there is a simple and quick way to estimate investment gains. It works particularly well with a steady annual rate of return but can be useful for many different investment scenarios. It uses the power of compounding where your investment returns accelerate over time because you earn interest on both your initial principal investment and on the interest/gains you have accumulated and left in the investment. Here is what you need to know when using the Rule of 72.
What is the Rule of 72?
The Rule of 72 is a mathematical formula you can use to calculate how long it will take for an investment to double in value, presuming it has a steady annual rate of return. Simply divide 72 by the annual rate of return for an investment. If an investment has an expected annual rate of return of 6%, that means it can be expected to double in 12 years.
The Rule of 72 has been around since the 15th century and the shortcut has broader applicability, particularly as inflation and interest rates have hit multi-decade high levels in recent years.
It is a quick tool, but because it doesn’t take into account future contributions, dividends, fees, taxes or inflation, it doesn’t tell the full story of investing. Therefore, it should be used as a guide, not as a gospel.
How to calculate the Rule of 72
You don’t need any advanced degree in mathematics as there is only one data point you need for the Rule of 72: the expected annualized rate of return for an investment. With this information, you can calculate the number of years it will take for that investment to double in value. The formula is:
72 ÷ expected rate of return = the number of years for investment to double in value
It’s most accurately used when considering investments with a steady and fixed rate of return, including bonds or certificates of deposit. It’s also most accurate for investments with annual rates of return ranging from about 5% to 10%, though it can be used for a rough estimate outside of that range.
Example of the Rule of 72
To appreciate how this rule may be beneficial in forecasting future returns, consider the following three examples, based on currently available rates:
An investment in the S&P 500 has an expected annual rate of return of 9% (based on historical returns), that means it can be expected to double in 8 years.
That same investment in a long term CD paying 4.5% will take 16 years to double.
Leave that same investment in your bank’s savings account earning .05% and it will take 1,440 years to double in size.
You can also pivot the Rule of 72 to predict how inflation will cut your purchasing power in half or how quickly quickly credit card debt or student loan debt will double in size if you don’t pay down the balance.
How Accurate is the Rule of 72?
The Rule of 72 is fairly accurate, as calculations go, particularly for rates of return within that range of about 5% to 10%. Outside of that range, it’s less precise and its real world applicability is made all the more problematic by the nature of investment returns.
It’s going to be less accurate with fluctuations in the rate of return, so stocks are going to be harder to pin down a Rule of 72 on and should never be used to predict how long it will take to double the value of your dental practice.
The rule is best used as an approximation when comparing investments with a predictable rate of return.
How to use the Rule of 72 in investment planning
Even though the Rule of 72 isn’t a perfect formula for calculating your investment performance, it can help you with investment planning. You can use the rule as a guide when defining realistic financial goals and choosing investments that match your risk tolerance.
One of the most valuable aspects of the rule is quantifying how long it takes for an investment to double in value can be eye-opening. On the positive side, you may be shocked to realize how long your investment in a low interest savings account will take to double and find another low risk investment that can cut that time in half or more. On the downside, you could be lured into an investment promising 18% so you can double your investment in 4 years but forget the risk of losing everything with any investment promising 18%.
Most importantly, the Rule of 72 can help you think about risk tolerance and realize that the rate of return is important. It can provide understanding to the reason for riding out periods of volatility in markets and help you visualizing the power of time in investing.