Investments without goals are like driving without a destination. Value investors always look multiple years ahead before they invest in a financial asset. They plan their investments based on the previous performance of the asset and the rate of interest. They believe in the logic that if you know how much the financial asset is offering as returns, you can avoid losses and ensure hefty returns.
Most investors have a time horizon for every investment they make. For example, you can invest for a minimum of two years but stretch it to three or four years if the predetermined goals are not met. These goals are generally relative to overall returns. If an investment doubles in value within a minimum period of two years, an investor will sell and take profits. But how to know when it will double?
This is where the Rule of 72 helps investors.
About Rule 72?
The Rule of 72 is a trading method used by investors to determine and understand the time it will take for an investment to double based on the fixed annual rate of interest, and can be implemented using an online trading app. The Rule of 72 is quite simple and straightforward and requires 72 to be divided by any financial instrument’s annual rate of interest. The result gives a rough estimate of the time it will take to double the investment’s value.
The Rule of 72, being a mathematical equation, only works with investments with a fixed annual interest rate. Furthermore, it is generally better to use the Rule of 72 with investments that have a compound interest rather than simple interest. However, investors can use the Rule of 72 for investments that do not have a fixed interest rate by analyzing an asset and assuming its estimated rate of return. For example, an investor can analyze the past performance of a stock and estimate that it can offer 15% annual returns and use this assumption within the Rule of 72.
How can you use the Rule of 72?
You can use the Rule of 72 to determine the value doubling time if you know the annual fixed rate of interest. The Rule of 72 will not work if the rate of interest fluctuates or is reset after a specific period. Moreover, the Rule of 72 works better with a lower rate of interest when compared to a higher rate of interest.
The Rule of 72 helps you to estimate the number of years required to double your money at a given annual rate of return. Hence, if the rate of return is 8%, the number of years taken to double your money is 72/8= 9 years. Or, conversely, if an investment adviser claims that the money invested in a debt plan will double in 8 years, the rate of return should be 72/8 = 9% p.a.
The formula to use the Rule of 72 is as follows:
The Rule of 72:
Number of years to double the investment = 72/ annual rate of interest
For a better understanding of the Rule of 72, consider the following detailed example:
Suppose you have invested in a Bond that has a fixed coupon rate of 6%. Before you invest the amount, you set a goal that you want to double your investment, and once doubled, you will sell the bond Now, you want to know the number of years you will have to hold the bond until the investment doubles. In this case, you can use the Rule of 72 as mentioned below:
Number of years to double the investment = 72/6
As the result is 12, it will take 12 years at the same rate of interest for your bond investment to double. This is how investors use the Rule of 72 to have a clear vision of the value of their investments after a specific period in the future.
Advantages and Disadvantages of Rule of 72
The advantages and disadvantages of the Rule of 72 include:
Advantages:
- It is a simple method that can be used by any investor instantly.
- It allows investors to determine the time it will take to double their investments
- Investors can adjust their risk exposure and positions accordingly.
- It gives investors a clear horizon about the period their invested holdings until they can sell them for double the profit.
- It can be applied to any market factor such as GDP, population rate, etc., as long as there is an estimated annual rate of interest.
Disadvantages:
- The Rule of 72 is mostly accurate for a lower rate of returns between 6-10%. For anything higher, the estimated value can fluctuate.
- It is not an accurate value and can only give a rough estimation of the period for doubling the investment.
- If the interest rate changes because of some factor, the Rule of 72 becomes void and unusable.
- The Rule of 72 does not work with investments that have a changing interest rate and for investments with simple interest.
Rule of 72 vs 70
Among the numerous rules used by investors along with the Rule of 72 are the Rules of 70, 69, and 69.3. The Rule of 70 also uses the same formula, with 72 being replaced by 70 and divided by the annual interest rate of any investment.
Among the two rules, investors prefer the Rule of 72 over 70 as it is a convenient choice of the numerator, having many small divisors such as 1, 2, 3, 4, 6, 8, 9, and 12. It makes up for a better choice for understanding and determining the compounding effect of the period and rate of return. However, the Rule of 70 is also a good numerator as far as the interest rates are lower than 6% and provides a better estimate than the Rule of 72.
The Rule of 72 is an effective method to determine for how many years you have to hold your investments until they double in their value. By dividing 72 with your investment’s annual rate of interest, you can have a clear horizon of the period and the profits you stand to make. The Rule of 72 ensures you avoid uncertain situations of losses and don’t sell before the expected returns are achieved. If you want to understand further about the various thumb rules you can use to ensure profitability, you can contact IIFL to understand the Rule of 72 along with other investing rules.
