How the Rule of 72 Works
The Rule of 72 is a mathematical formula that allows you to estimate the amount of time it will take for your capital to double based on a specified rate of return. It’s a good educational tool to illustrate the effects of different rates of return, but it is a poor tool for predicting the future value of your savings, especially as you approach retirement and need to be more cautious about how you invest your money.
How the Rule of 72 Works
To use the rule, divide 72 by the rate of return (the interest rate your money will earn). The answer will tell you how many years it will take to double your money.
For example:
If your money in a savings account earns 3% annually, it will take 24 years to double your money (72 / 3 = 24).
If your money is in a stock mutual fund that you expect to average 8% annually, it will take you nine years to double your money (72 / 8 = 9).
As an Educational Tool
The Rule of 72 can be useful as an educational tool to illustrate the risks and outcomes associated with short-term versus long-term investing.
When it comes to investing, if you’re using your money to achieve a short-term financial goal, it doesn’t matter much whether you’re achieving a 3% or 8% rate of return. Since your destination isn’t far off, the extra yield won’t make much of a difference in how quickly your money accumulates.
It’s helpful to look at this picture with real money. Using the Rule of 72, you see that an investment yielding 3% doubles your money in 24 years; whereas an investment yielding 8% only takes nine years. That’s a big difference, but what is the size of the difference after just one year?
Suppose you have $10,000. After one year, in the savings account with a 3% interest rate, you will have $10,300. In the stock mutual fund yielding 8%, you will have $10,800. There’s not much of a difference.
Extend that to the ninth year. In the savings account, you will have roughly $13,050. In the stock index mutual fund, according to the Rule of 72, your money has doubled to $20,000.
That’s a much larger difference that grows over time. In the next nine years, you will have about $17,000 in savings but about $40,000 in your stock index fund.
In the short term, an increase in the rate of return doesn’t have a big impact. But in the long term, it has a significant effect.
Is the Rule Useful as You Approach Retirement?
The Rule of 72 can be misleading as you approach retirement.
Suppose you are 55 years old and have $500,000 and expect to earn about 7% on your savings and double it over the next ten years. You plan to have a million dollars by age 65. Will you achieve this goal?
Maybe yes, maybe no. Over the next ten years, the markets could yield higher or lower than the average that individuals expect.
Because your time window is shorter, you have less capacity to absorb and correct any market fluctuations. By relying on something that may or may not happen, you may save less or neglect other important planning steps like annual tax planning.
Note: The Rule of 72 is a fun mathematical concept and a good educational tool, but it should not be relied upon to calculate your future savings.
Instead, make a list of everything you can control and things you cannot control. Can you control the rate of return you achieve? No. But you can control:
- The level of risk in the investment
- The amount of savings
- How often you review your plan
Less Useful After Retirement
Once
In retirement, the main concern is generating income from your investments and understanding how long your money will last, depending on the amount you take out. The Rule of 72 does not assist in this task.
Instead, you should consider strategies like:
- Time distribution, which involves matching your investments with the time you’ll need to use them
- Withdrawal rate rules, which help you determine how much you can safely withdraw each year during retirement
The best thing you can do is set up a timeline for your retirement income to help you visualize how the pieces will fit together.
If financial planning were as easy as the Rule of 72, you might not need professional help. In reality, there are many variables to consider.
Using a simple mathematical equation is not the proper way to manage money.
Frequently Asked Questions (FAQs)
What interest rate will double your money in five years?
You can use the Rule of 72 in reverse to work backwards from your time goal. If you want to double your money in five years, divide 72 by five. According to the Rule of 72, it will take about 14.4 years to double your money at an annual rate of 5%.
Does stock splitting double your money?
No, stock splitting does not double your money. Your brokerage will automatically adjust the price of each share after the split. In a 2-for-1 split, each share will be worth half of its previous value. In a 3-for-1 split, each share will be worth a third of its previous value.
Source: https://www.thebalancemoney.com/how-to-use-the-rule-of-72-2388567
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