Have you ever heard of the Rule of 72?
It’s one of those personal finance calculators that’s been around for a while, and it’s about as basic as it gets. Yet, it’s been used by some people to quickly project results for a given investment over time.
The rule is essentially a quick way to determine how long it will take you to double your money at a current rate of return. It works as follows: start with the number 72, and divide it by the rate of return of an investment over time. The result will be the number of years it will take to double your money.
Let’s say you have an investment that will earn you a total annual return of 3%. It would then take you 24 years to double your money (72/3 = 24). Too long? Well, jack that rate of return up to 6%, and it will then take you just 12 years to double your money.
While I consider myself to be analytical, and comfortable with complex calculations, I do like such tricks such as the rule of 72. They allow us to quickly, on the fly, do some basic calculations. In this case, we all could have quickly divided 72 by 3 (or 6) in our minds to get the answer in just a matter of seconds.
For whatever reason, this one in particluar has struck me as being nice for those of us who gravitate toward investment growth thoughts. It”s a quick way to think about what money could become in the future.
As with any shortcut, however, there are pitfalls. There are three that I see with the Rule of 72:
- Taxes. If you’re paying taxes on earnings, this needs to be considered in any calculation. So, if you’re earning 6%, but will pay some tax on that, your after tax rate may actually be somewhere in the neighborhood of 4% or so. This needs to be factored in, or the Rule of 72 will give you erroneous results.
- Inflation. Let’s say you’re earning 3% after taxes for example. If inflation is 3%, you’re not really getting ahead. The $1,000 you have invested will turn into $1030 a year later, but will still buy the same amount of goods as $1000 did the year before. So, inflation needs to be taken into account.
- Accuracy. This rule is meant to be a shortcut, so it’s not 100% accurate down to the decimal point. For example, if you wanted to see how long it would take to grow a $1000 investment into $2000, with a 3% rate of return, the Rule of 72 would tell you 24 years. If you calculate it manually, it actually comes out to almost 23 1/2 years. Close enough for an quick estimate, but important to note that it is in fact an estimate.
Personally, I find that many quick financial projections, particularly those that are intended to show the power of compounding over time, tend to ignore both taxes and inflation. To the latter point, always keep in mind the time value of money.
In any event, as long as we’re aware of it’s limitations, the Rule of 72 can be a useful tool for quick projections of how long it will take us to double our money.
My Questions For You:
Have you ever used the Rule of 72?
Do you ever stop to question assumptions in such financial projections, such as I did with taxes and interest?