Compound interest is the most powerful force in investing. By allowing our investments to grow through the magic of compounding, an investment of $50,000 can grow to $1,000,000 over a 40-year investment period at a rate of return of just under 8%.
We see interest rates and rates of return, but it is not always clear how these affect our future wealth. The Rule of 72 is a useful tool to understand the effect of different interest rates on the growth of our investments. The Rule of 72 can be used to determine (approximately) how long it takes for an investment to double using a given rate of return. The way the rule works is you divide 72 by the annual rate of return to determine the number of years for one doubling to occur. For example, at an annual rate of return of 7.2%, your investment will double in 10 years (72 / 7.2 = 10). Here are some more examples:
|Rate of Return||Years to Double|
The Rule of 72 is helpful for retirement planning and investment allocation. Often, we are presented with different portfolios that may only have a 1-2% difference in annual return. These scenarios may be presented in the following (hypothetical) way: You can invest in your current portfolio, earn 6% per year, but potentially lose 30% in a downturn. Or, you can invest in a more conservative portfolio, earn 4% per year, and only lose 12% in a downturn. Without understanding the effect of compounding, many choose the more conservative portfolio since the difference in return is only 2% per year.
Let’s see how a “small” difference in rate of return would affect wealth growth over 36 years, a timeframe that is representative of our working career. Using the Rule of 72, $100,000 invested for 36 years at a rate of return of 4% will grow to $400,000 (2 doublings). On the other hand, $100,000 invested for 36 years at a rate of return of 6% will grow to $800,000 (3 doublings). If you could earn a rate of return of 8%, your $100,000 investment would grow to $1.6 million (4 doublings)! The Rule of 72 is an approximation so these numbers are not exact. The difference in wealth accumulation over a typical working career can be huge.
An investing strategy needs to take into account a number of factors. These include your age, time horizon, risk tolerance, and accumulation goals. The Rule of 72 is a valuable tool to help you understand how differing rates of return effect your accumulation goals.
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