Have you recently discovered the power of compound interest when it comes to investing? You’re going to love discovering the Rule of 72: it’ll help you quickly simplify and master the concept of compound interest. Whether you’re saving or investing, you’ll find that it can be applied to a wide range of situations.
In this article:
- Definition and operation of the rule
- Practical examples
- Advantages and disadvantages of the rule of 72
- Integrating the rule of 72 into your investment strategy
What is the rule of 72?
The Rule of 72 is a simple but powerful mathematical formula used to estimate the time required to double an investment thanks to a compound fixed interest rate.
The rule is particularly useful for getting a quick idea of the effect of compound interest without having to perform complex calculations.
The formula for the rule of 72 is as follows:
Time to double = 72 / annual interest rate expressed in %.
Simple enough, isn’t it?
To use this formula correctly, all you have to do is divide 72 by the annual interest rateof your investment.
You’ll get a rough estimate of the number of years it will take for your investment to double. That’s all there is to it!
Example of using the rule of 72
Let’s take a few simple examples to illustrate the rule in different scenarios.
Fixed-rate savings account
As a saver, you decide to invest part of your savings in a certain product. The product pays an annual interest rate of 3%.
Using the rule of 72, you can find out how long it will take to double your money, based on the investment’s interest rate.
Following the rule, simply divide 72 by 3 :
Time to double = 72/3 = 24.
Conclusion: you’ll need to leave your capital for around 24 years for this investment to double in value.
Investing in the stock market
Now let’s say you invest in an ETF or in equities with an average annual return of 7%.
By applying the formula of the rule of 72 :
Time to double = 72/7 = 10.3
Here, your stock market investment would double after about 10.3 years, which is significantly faster than the savings account.
Please note that this rule is an estimate and may not be accurate in all scenarios: for example, if the interest rate on the investment or the yield on the stock changes over time, the initial calculation will no longer be correct.
The rule of 72 for understanding inflation
The rule of 72 can also be used to understand the effect of inflation on your purchasing power. Let’s use the formula with inflation at 2% per year:
Time to overtake = 72/2 = 36
This means that the cost of living will double in approximately… 36 years!
The 2% example has nothing to do with reality today. Let’s test it with the current inflation rate, which is around 5%:
Time to overtake = 72/5 = 14.4
If inflation continues at its current rate, the cost of living will have doubled in 14 years.
That’s why it’s crucial to think about retirement planning and achieving your financial goals!
Advantages and disadvantages of rule 72
The rule of 72 offers a simple and effective way to appreciate the power of compound interest... But is this its only advantage? And is it perfect? Let’s take a look at the advantages and disadvantages of this rule.
Advantages of the rule
- Simplicity: one of the main advantages of the Rule of 72 is its simplicity. No need to use a financial calculator or spreadsheet to get an estimate, you can use the Rule of 72 instead to get a quick result.
- Versatility: the rule can be applied to various types of investment, from savings accounts to stock market investments, and as we’ve seen together, it can be useful in understanding how to cope with inflation.
- Financial planning: it enables you to make quick decisions when comparing different investment opportunities, which is very useful for financial planning if you’re hesitating between 2 types of investment, for example, to find the one that will double your money the fastest.
Disadvantages of the rule
This is the rule’s “only” flaw, but it’s an important one.
Bear in mind that the rule of 72 is an approximation. It cannot be relied upon to provide an ultra-precise view.
This is particularly the case when you have variable interest rates or additional periodic contributions, since the rule of 72 only works if you leave the initial capital untouched and your rate is resolutely fixed (which is rarely the case in finance).
For these more sophisticated investor calculations, or when large amounts of capital are involved, methods involving the use of financial calculators or complex mathematical models are more appropriate.
The problem with these other calculation methods and tools lies in the costs and skills required: they are more expensive and require a certain amount of expertise before they can be used.
Integrating rule 72 into your investment strategy
As we’ve seen, the Rule of 72 is an interesting tool to use when planning your future returns. Here are a few more practical tips for using the rule in your investment strategy. We’ll take you through them step by step.
1 – Evaluate opportunities
The first application of the Rule of 72 is before you invest your money: you can compare different investment opportunities.
For each scenario, this will give you an idea of the investment performance, amount and time required to double your investment.
Scenario 1 could be where you decide to invest 10,000 euros in a Livret A passbook and 10,000 euros in the stock market, in several shares.
Scenario 2 would be when you decide to invest 20,000 euros directly in the stock market.
Based on your financial objectives, you’ll be able to understand the best scenario for your needs and make informed decisions.
2 – Factor inflation into your calculations
Inflation erodes your purchasing power, year after year, and this will be even truer in 2023 with galloping inflation!
Use the rule of 72 to estimate how long it will take before the cost of living doubles.
Let’s not minimize this step: it will really help you choose investments that outperform inflation over the years, thus preserving the real value of your assets.
3 – Plan your retirement
The goal here is to determine how long it will take you to reach your financial goal for retirement.
For example: if you’ve already saved a certain amount of money and are planning to invest it in the stock market to make it grow with an annual return of 5%, the rule of 72 allows you to estimate the number of years needed to double this sum of money.
4 – Diversify your portfolio
The rule of 72 can also be used to diversify your portfolio!
If you use it to measure returns, you’ll be able to estimate the time needed to double different types of assets. In this way, it’s fairly simple to balance risk and return in your portfolio.
5 – Measure debt
Last but not least! The rule of 72 goes beyond use to investment.
It can also be used to understand the impact of interest rates on your loans and debts. Before taking out a loan, it will provide you with valuable information on how long it will take to repay a sum.
The Rule of 72 can be used in a number of situations, including to determine when your money will double. It’s an indispensable tool for gaining an overview of an investment’s performance. Remember, these are just estimates! The Rule of 72 can give you some guidance, but should not be your final source of decision if you decide to invest large sums in products with complex returns.
Passionate about savings and investment topics. I modestly try to offer you simple, sometimes not so simple, solutions to beat inflation.