Tuesday, November 17, 2015

The Rule of 72

How long does it take to double you investment? The obvious answer you be "it
depends on the rate of return."

But even if you know the expected rate of return it can be a lot of math unless you
have a financial calculator or know how to do time value of money calculations in
excel. The trick that I want to show you today will allow you to make a fairly close
estimate with a basic calculator or even in your head.

The Rule of 72

The rule of 72 says that if you divide 72 by the expected rate of return you will get the
expected number of years for your investment to double. Yes, it really is that simple.
But let's dig in a bit anyways because it can be a useful trick.

Let's assume that you are investing in an indexed fund that follows the S&P 500 (a very
wise investment by the way). History shows that you can expect to average about a
10% rate of return.

 So, 72÷10=7.2

You can expect your initial investment to double every 7.2 years. Simple as that.

But how accurate is it?

Let's assume that you invest $100 in a fund that averages a 10% return year over year.

Year.      Value
Today.   $100
1 year.   $100×10%=$10+$100=$110=$100×1.1%
2 years.  $110×1.1%=$121
3 years.  $121×1.1%=133.1
4 years.  $133.1×1.1%=$146.41
5 years.  $146.41×1.1%=161.05
6 years.  $161.05×1.1%=$177.16
7 years.  $177.16×1.1%=$194.87 (getting close)
8 years.  $194.87×1.1%=$214.36

So it seems rationale to assume that we would have reached the $200 mark about year
7.2.

If I were to put in the same information into a financial calculator it says that the time
to double or $100 initial investment would be approximately 7.2725 years. Which is
only about 26.5 days off. Not bad for an estimate that you could have done in your
head.

Implications?

Start investing early, or now if you think that early has already passed for you. Keep expense ratios low so you can retain as much of the gains as possible. Over a 60
year time frame, 1% makes a huge difference in your returns.