An Introduction To The Rule of 72
There is so much power in compounding interest, and when it comes to your retirement savings, that power shouldn’t be overlooked. Have you ever heard of the Rule of 72? It can be used as a quick rule of thumb to help determine how long it will take to double your investment, assuming a fixed rate of return.
What Is the Rule of 72?
The Rule of 72 is a commonly used formula that estimates the amount of time it will take an investment to double in value if it earns a fixed annual rate of return.
72 / interest rate = years to double
Divide 72 by the annual rate of return you want to use. This will give you an idea of many years you can expect to wait for your investment to double in value.
It is important to note that there are scenarios in which a different formula may provide a more accurate answer. The Rule of 72 should only be used as an estimate as this is not an exact science.
How Does the Rule of 72 Work?
For instance, let’s say someone invests $30,000 in an ETF with an estimated annual 6% rate of return.
Using the Rule of 72, the formula would be:
72 / 6 = 12
Based on this, the original investment can be expected to be worth $60,000 in roughly 12 years.
Determine Compound Interest
The Rule of 72 can also be used in the reverse, helping to estimate how much compound interest your investment has already earned. As an example, we’ll say you invested $50,000 and it took 10 years to become $100,000. By rearranging the formula, you are able to determine your average rate of return for those 10 years.
In this example. the formula would be:
72 / 10=7.2
You can calculate your average rate of return as 7.2%.
Considerations for the Rule of 72
There are a few considerations to keep front of mind while using the Rule of 72.
It’s Only an Estimate
The Rule of 72 is best used to provide a general estimation as it is not precise or perfect. Past market performance does not guarantee future returns. While you can estimate an average rate of return based on market performance (or using other benchmarks), there is never a guarantee.
Precision Is Limited
Further, studies have shown that the Rule of 72 tends to work best when using average rates of return between 6% and 10%.1 When using estimates outside of this window, a different, more precise formula may be needed.
Best for Long-Term Investors
If you’re getting near retirement, you’ll most likely want a very precise picture of what your post-retirement income and savings will look like. This estimate is crucial to identify any potential income gaps and in developing a tax-efficient withdrawal plan. Broad estimations like the Rule of 72 may not be suitable for your needs because of this need to be precise. Additionally, having a shorter period of time before retirement means there is less room for market corrections should a downturn occur.