The Rule of 72 is one of those very simple and very useful tools that you can use in many aspects of your financial life. It is most often used to answer the question, "How long will it take to double my money?" However you can also use it as part of an assessment of your investment strategy or to make projections about the impact of inflation.
How does it work and how can you use it? Read on to find out.
The Rule of 72
What is the rule of 72? It's very simple: You just take the number 72 and divide it by your annual estimated (or desired) rate of return, and the number it gives you is the approximate number of years it will take for your money to double. For example, say you have an account that you would like to see returning 8 percent per year:
72 ÷ 8 = 9 years to double your money
The rule also works for inflation: You can divide 72 by the inflation rate to find out how long it will take for the cost of goods and services to double. So, if inflation is 2 percent:
72 ÷ 2 = 36 years for prices to double
For more information about how the Rule of 72 works, have a look at this video here.
Using the Rule of 72
While knowing the time it takes to double your money might just seem like a fun exercise, you can also use it as part of an overall strategy. I like to use it to get a back-of-the-envelope assessment of the risk in an account, and to help clients think about how much they should be saving and how much risk is appropriate for them.
For example, take your current retirement savings balance and its average rate of return, and use the Rule of 72 to figure out how long it will take to double the money. Now think about how much money you want to save for retirement.
Warning: This can be a scary exercise! But it usually illustrates the importance of regularly contributing enough to your retirement account and of choosing the appropriate investment strategy for your needs. If you wait to contribute or contribute too little, you might feel that you need to take on unnecessary risk in order to get to your savings goal. Instead of putting yourself into a corner, contribute regularly now, and contribute enough so you're not rolling the dice as you approaching retirement.
Understanding the Rule of 72 can help you balance the contribution amount and the risk taken over your lifetime. When you're younger, it can be difficult to contribute a lot to your 401(k) or IRA because you're earning less, but you can also take on more risk because you have a longer way to go to retirement. As you get older, you might use the Rule of 72 to remind yourself to increase your contributions while perhaps decreasing the risk you take on.
The Limits of the Rule of 72
The Rule of 72 can be a great way to quickly assess the risk and reward of an investment strategy and a useful tool to illustrate the importance of contributing as much as possible to retirement.
Of course, the Rule of 72 also has its limitations: It's an approximate tool, not an exact one, so don't use it to get a specific estimate of your future returns. Also, remember that it is unknown what your performance will be from one year to another. Yes, taking more risk can give you higher average returns, but it can also give you larger losses. Over the long run, higher risk investments return more, but you should be aware of your overall risk profile when making investment decisions.
To get a better estimate of your returns, you'd need to use the Future Value formula or an online calculator. It's also important to note that the Rule of 72 doesn't allow for new contributions to be taken into account; it just tells you the approximate doubling time for a specific lump sum of money. To get a more detailed picture, you'll need to use more complicated formulas, like the Future Value formula mentioned above.
So, for quick estimates or to illustrate the risk in your strategy, use the Rule of 72 -- but as with most tools, remember to use it wisely.
Written by Bradford Pine with Anna Wroblewska.