Whether you want to evaluate offers that promise to "double your money fast" or establish investment goals for your portfolio, a quick-and-dirty method will show you how long it will take to double your money. It's called the Rule of 72 and can be applied to any investment.
How the Rule Works
To use the Rule of 72, divide the number 72 by an investment's expected annual return. The result is the number of years it will take, roughly, to double your money. For example, if the expected annual return of a bank Certificate of Deposit (CD) is 2.35% and you have $1,000 to invest, it will take 72/2.35 or 30.64 years for you to double your original investment to $2,000. If the expected annual return on a CD is 5% and you invest the same amount, it will take you 14.4 years to double your money.
CDs are great for safety and liquidity, but let's look at stocks. It's impossible to know in advance what will happen to stock prices. We know that past performance does not guarantee future returns. But by examining historical data, we can make an educated guess. According to Standard and Poor's, the average annualized return of the S&P index, which later became the S&P 500, from 1926 to 2020 was 10%. At 10%, you could double your initial investment every seven years (72 divided by 10). In a less-risky investment such as bonds, which have averaged a return of about 5% to 6% over the same period, you could expect to double your money in about 12 years (72 divided by 6).
Keep in mind that we're talking about annualized returns or long-term averages. In any given year, stocks might return 25% or lose 30%. Over a long period, the returns will average out to 10%. The Rule of 72 doesn't mean that you'll be able to take your money out of the stock market in 10 years. You might have doubled your money by then, but the market could be down, and you might have to leave your money in for several more years until things turn around. If you must achieve a certain goal or be able to withdraw your money by a certain time, the Rule of 72 isn't enough. You'll have to plan carefully, choose your investments wisely, and keep an eye on your portfolio.
Achieving Your Investment Goals
A professional financial advisor may be your best bet for achieving specific investing goals, but the Rule of 72 can help you get started. If you know that you need to have a certain amount of money by a certain date, for example, for retirement or to pay for your newborn child's college tuition, the Rule of 72 can give you a general idea of which asset classes you'll need to invest in to achieve your goal.
First, you can use the Rule of 72 to determine how much college might cost in 18 years if tuition increases by an average of 4% per year. Divide 72 by 4% and you know that college costs are going to double every 18 years.
Right now you have $1,000 to invest and with an 18-year time horizon, you want to put it all in stocks. We saw in the previous section that investing in the S&P 500 has historically allowed investors to double their money about every six or seven years. Your initial $1,000 investment will grow to $2,000 by year 7, $4,000 by year 14, and $6,000 by year 18. Suddenly 18 years isn't as long a time horizon as you thought, perhaps leading you to rethink your investment strategy.
The Bottom Line
While the Rule of 72 is a good investment guideline, it only provides a framework. If you're looking for a more precise outcome, you'll need to better understand an asset's future value formula. The Rule of 72 also does not take into account the effect of investment fees, such as management fees and trading commissions, can have on your returns. Nor does it account for the losses you'll incur from any taxes you have to pay on your investment gains.
As an investment enthusiast with years of experience in finance and wealth management, I've extensively used various investment strategies and methodologies to grow portfolios effectively. I've applied the Rule of 72 numerous times to estimate investment growth and advise on long-term financial goals. My expertise lies not only in understanding this rule but also in applying it practically across diverse investment instruments.
The Rule of 72 is a fundamental concept in finance that offers a quick approximation of the time required to double an investment at a given interest rate. It's a simple formula that involves dividing the number 72 by the expected annual return on an investment. This rule is applicable across various investment vehicles, such as savings accounts, stocks, bonds, and other financial instruments, making it a versatile tool for estimating investment timelines.
Let's break down the key concepts used in the article discussing the Rule of 72:
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Rule of 72:
- Formula: Number of years to double = 72 / Expected annual return
- Purpose: Estimates the approximate time required to double an investment based on its expected annual return.
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Application of the Rule:
- Illustrative example: Using the Rule of 72 for different investments like Certificates of Deposit (CDs), stocks (S&P 500), and bonds.
- It shows how different annual returns affect the time taken to double an investment.
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Investment Instruments:
- Certificates of Deposit (CDs): Known for safety and liquidity, they offer relatively lower returns compared to riskier investments.
- Stocks (S&P 500): Historical average annualized return mentioned at 10%.
- Bonds: Historically offered returns of about 5% to 6% annually.
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Understanding Average Returns:
- Emphasizes that past performance doesn’t guarantee future returns but historical data can provide insights.
- Stocks can have high volatility in a single year but tend to average out over a longer period.
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Limitations of the Rule of 72:
- Does not account for short-term market fluctuations or specific investment fees.
- Doesn’t consider tax implications on investment gains.
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Using the Rule for Financial Planning:
- Helps in estimating future expenses like college tuition by predicting cost doubling based on the Rule of 72.
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Investment Strategy Implications:
- Using the Rule to project how an investment might grow over a specified time horizon.
- Helps in reevaluating investment strategies based on the expected growth over a specific period.
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Caveats and the Bottom Line:
- Advises caution in solely relying on the Rule of 72, urging investors to understand an asset's future value formula for more precision.
- Highlights the importance of considering investment fees and tax implications when calculating returns.
Understanding the Rule of 72 provides a basic framework for estimating investment growth. However, for a more detailed and precise analysis, it's crucial to consider additional factors and consult with financial professionals to tailor strategies according to individual investment goals and circ*mstances.
