Not as Practical as Legal Planning, but a Fun Rule
For any given rate of return, you may calculate how long it will take to double your nest egg using the Rule of 72. It is an effective teaching tool for demonstrating the effects of various rates of return, but it is a poor tool for estimating the future worth of your savings, especially as you go closer to retirement and must be more cautious with your money’s investments.
Find out more about this rule’s application and the most effective method to use it.
How the Rule of 72 Works
Divide 72 by the investment return to apply the formula (the interest rate your money will earn). The response will reveal how many years it will take for your money to double.
It will take 24 years to double your money if it is in a savings account paying 3 percent annually (72 / 3 = 24).
It will take you nine years to double your money if it is invested in a stock mutual fund with an expected annual return of 8% (72 / 8 = 9).
If you don’t want to perform the calculations yourself, you can use a Rule of 72 calculator.
As a Teaching Tool
To demonstrate the risks and results of short-term versus long-term investing, the Rule of 72 might be helpful as a teaching tool.
When it comes to investment, it doesn’t really matter whether you make an 8 percent or a 3 percent return if your money is used to achieve a short-term financial goal. Given how close your final destination is, the additional yield won’t have much of an impact on how rapidly you create wealth.
Putting this image in terms of actual money is helpful. According to the Rule of 72, an investment yielding 3 percent will double your money in 24 years whereas one yielding 8 percent will do it in nine. That’s a significant difference, but what about after just a year?
Consider that you have $10,000. You have $10,300 after a year in a savings account earning 3% interest. You have $10,800 in the mutual fund generating 8 percent. Not much of a distinction.
Increase that to nine years. Your savings balance is roughly $13,050. According to the Rule of 72, your investment in the stock index mutual fund has grown to $20,000 from $10,000.
This is a significantly larger disparity that just becomes bigger with time. You will have around $17,000 in savings in nine more years, but you will have roughly $40,000 in your stock index fund.
Earning a higher rate of return has less effect during shorter time periods. It does over a longer period of time.
Is the Rule Useful As You Near Retirement?
When you get close to retirement, the Rule of 72 can be deceptive.
Assume you have $500,000 and are 55 years old. You predict that over the next ten years, your savings will grow by around 7%. When you are 65, you want to have $1 million. Then you?
Perhaps, perhaps not. The markets might offer a larger or lower return over the following ten years than what you might anticipate based on averages.
Your window of opportunity is smaller, so you have less time to take market swings into account and make adjustments. You run the risk of saving less money or skipping other crucial planning tasks, such as annual tax preparation if you rely on something that may or may not happen.
The Guideline of 72 is an excellent teaching tool and a fun math rule, but you shouldn’t use it to figure out how much money you should save up for the future.
Make a list of everything you can control as well as everything you cannot. Can you influence the rate at which you will make money? No. However, you have some degree of control.
- Your investment risk tolerance
- Your level of savings
- When do you evaluate your plan?
Even Less Useful Once in Retirement
When you are retired, your major concerns are deciding how much income to take from your investments and how long your money will last. The Rule of 72 is ineffective for this endeavor.
Instead, you should consider methods like:
- Matching your investments to the time when you will need to use them is known as time segmentation.
- Rules for withdrawal rates that can assist you in determining how much money you can comfortably withdraw each year during retirement
The best thing you can do to help you picture how the pieces will fit together is to create your own retirement income plan timeline.
You might not want the assistance of a professional if financial planning were as simple as applying the Rule of 72. In actuality, there are just too many factors to take into account.
Money management cannot be accomplished by solving a straightforward mathematical equation.
Frequently Asked Questions (FAQs)
What rate of interest would cause your money to quadruple in five years?
Utilize the Rule of 72 in reverse to move backward from your timing objective. Divide 72 by five if you want to double your money in five years. The Rule of 72 states that it would take 14.4 years to double your money at a rate of 5 percent annually.
Will your money double if a stock splits?
No, a stock split won’t make your money twice. Following the split, your brokerage will immediately change the value of each share. Each share will be worth half as much in a 2:1 stock split. Each share will be worth a third less in a 3:1 stock split.