The Most Important Number In Personal Finance
As a personal finance go-getter, your world is doubtlessly full of important numbers. Be they bank statements, phone contacts, bills, savings, or interest rates, it can often feel like there are just so many different things to keep track of! What’s a savvy saver and smart investor to do?
The “Rule of 72”, that is. Ever wanted to know how long it would take for an investment to double in value? Well, this rule will tell you – even if, like your humble author, you could hardly keep your thoughts straight in high school math. Investopedia says:
“The ‘Rule of 72‘ is a simplified way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return expressed as a percentage, investors can get a rough estimate of how many years it will take for the initial investment to duplicate itself.”
For example, if you have an investment with a 6% rate of return, your time to double will be 72 / 6, or 12 years. The actual math here is a little more complex, but the “rule” allows us to use a number that is easily remembered and easily divisible by a lot of different values.
This rule works both ways: if you want to know what rate of return you’ll need to double your investment in a certain number of years, divide 72 by the time frame desired. As another example, if you wished to double your money in ten years, you would divide 72 / 10 for a required rate of return of 7.2%
You can also use the rule of 72 for expenses like inflation or interest. If inflation rates go from 2% to 3%, your money will lose half its value in 24 years instead of 36. If college tuition increases at 5% per year (which is faster than inflation), tuition costs will double in 72/5 or about 14.4 years. If you pay 15% interest on your credit cards, the amount you owe will double in only 72/15 or 4.8 years! Now you can see just how applicable and valuable this rule is to many kinds of personal finance decisions.
Finally, the rule of 72 can also be used to demonstrate the long term effects of period fees on investments such as mutual funds, life insurance, or private equity funds. For example, not counting any appreciation or depreciation, a mutual fund with a 3% annual loading and expense fee on principal invested will cut the principal in half over 24 years. Many investors and financial consumers don’t realize the long term effect of small percentage changes like these until it’s too late.
While the Rule of 72 is an exceptionally useful shorthand for many types of calculations, keep in mind that it is merely a tool for making estimations. There are many external factors that will also affect the time frame in which an investment will double in value. These include the type of investment, its size and the volatility of the investment instrument or security. If you calculate the doubling times for an increasingly high rate of return, the results get less and less accurate. Similarly, as the size of an investment grows, it’s better to use a more accurate calculation to find out its doubling time. In these cases, the approximations inherent in the “rule” will cause noticeable errors in the final result, which could leave you out of pocket in the future.
One Number, One Plan
With all these caveats in mind, the Rule of 72 is still a great shorthand for personal financial planning – at least before you double check your plan with a qualified, accredited source such as an accountant or investment planner. If you’re looking for a quick way to sketch out the broader goals of your financial plan, start with the most important number you’ll need!