What is the “Rule of 72” And Why Does It Matter to You?
“In wanting to know of any capital, at a given yearly percentage, in how many years it will double adding the interest to the capital, keep as a rule [the number] 72 in mind, which you will always divide by the interest, and what results, in that many years it will be doubled. Example: When the interest is 6 percent per year, I say that one divides 72 by 6; 12 results, and in 12 years, the capital doubles.” Luca Pacioli, mathematician.
I am a firm believer that all investment decisions, including those having to do with deciding the percentage of stocks vs. bonds in a portfolio, must be based on a person’s unique financial situation. Factors such as the potential for future income, the timing of account distributions, current assets, and the overall retirement goal should always be taken into account.
Understand this; there are some rules of thumb and formulas that, when appropriately understood, can assist people in making the right decisions with their money.
You may have heard of one of these formulas. It’s known as the “Rule of 72,” and its’ origins can be traced back to back to the 1500s.
The first written explanation of this Rule appears around 1494 in a book written by mathematician and Leonardo da Vinci collaborator Luca Pacioli. Pacioli is also the inventor of the double-entry bookkeeping we use today and was one of the top mathematics professors of his time. As described by Pacioli, the Rule of 72 is a method of determining how long money in a particular investment will take to double if you have a fixed annual rate of interest.
By dividing 72 by the annual rate of return, you can estimate how many years it will take for a given investment to duplicate itself.
For example, if you have an investment with a 9% rate of return, you can divide 72 by nine and determine that it will take around eight years for that investment to double its’ value.
With returns higher than 9%, the accuracy of the Rule of 72 begins to falter. Many mathematicians suggest that for greater efficiency calculating higher rates of return, it’s better to use 69.3 instead of 72.
Why the Rule of 72 Is Important
I think the primary reason the Rule of 72 is a helpful tool for investors is that it brings the power of compound interest to light, especially for younger investors who may not understand the investing advantage of time. The Rule of 72 dramatically drives this critical understanding home.
However, you should note that there are some issues with becoming overly reliant on the Rule of 72 when considering purchasing a financial product.
For one thing, the Rule does not contemplate risk. You could become fooled into investing in something that seems to take less time to double but has twice the risk. Depending on where you are in your financial life cycle, taking on increased risk may not be a good idea.
Another reason you don’t want to depend only on the Rule of 72 for guidance is that it just not possible to predict or control returns. You can’t know for sure how well your stocks will do over ten years.
Finally, although the Rule of 72 can sometimes be useful, its’ focus on time and money may take your attention away from the bigger picture.
It cannot answer the most pressing questions of retirement and income planning, such as:
- Do I have enough income now?
- Will I have enough money to last until I die?
- What products and protocols will allow me to increase my income without taking on as much risk?
If you’d like a no-cost consultation that can help you answer these and other questions related to creating a happier, more prosperous retirement, please contact me today.