Rule of 72
When it comes to determining which investment option to invest in the Rule of 72 will help. The Rule of 72 is a simple way to determine how long an investment will take to double given an annual rate of return. Essentially, this formula will help you determine how long it will take for you to earn back the amount you invested. By dividing 72 by the annual rate of return, investors obtain a rough estimate of how long it will take for the initial investment to duplicate itself. To perform the calculation, take the number 72 and divide it by the annual return rate of your investment option. The annual return rate is the percentage of earnings the investment option is expected to earn each year on average. The formula for the Rule of 72 is as follows:
The estimated number of years it will take to double investment = 72 ÷ annual return rate.
For example, an investment with a six percent annual rate of return will take 12 years to double in value.
72 divided by 6 (rate of return) = 12 (number of years it will take to double an investment)
Note: It is important to enter the rate of return as a whole number (i.e., 6) rather than as a decimal (.06)
Starting with $1000 investment at age 18…
Which investment option below should you invest in for 50 years?
Rule of 72
Investment at Age 68
Traditional Bank Savings
72/.01 = 7,200 years to double
$1,005 at age 68 (does not double)
C.D. (6 year)
2.5% return 72/2.5 = 29 years to double
$3,437 at age 68 (1 3/4 doubles)
4% return 72/4 = 18 years to double
$7,107 at age 68 (2 3/4 doubles)
9% return 72/9 = 8 years to double
$74,358 at age 68 (6 1/4 doubles)
* Return rates based off historical averages.
Types of Investments
Traditional Savings/Money Market Fund: An investment that is returned on demand and pays interest annually. By investing money into a bank savings account, you are loaning the bank money and the bank can return this money to you at any time.
C.D. (Certificate of Deposit): This is a loan to a bank for a specified time, usually three months to five years. It is to be repaid in full of interest. Ultimately, the bank is borrowing your money to invest that money in options with a higher return rate. The bank is making money from investing your money and paying you a lesser percentage of those earnings.
Bond (Savings, Corporate, Treasury or Government): This is a loan to a company or government entity. It is returned after a specified time (predetermined maturity date) with interest payable each year. For example, if Cleveland City Schools wanted to build a new public high school, they would issue bonds for a certain period to raise the funding from investors to complete the build. During that time frame they sell and trade the issued bonds in the marketplace in efforts to earn return to fund the project and pay the investors.
Stock (Equity): A share of ownership in a company which is also referred to as shareholder’s equity. As the value of the company rises or falls, so does the value of the share. The company’s value is determined by taking the company’s total assets (what they own) and subtracting their total liabilities (what they owe). As debts are paid off, the company’s value increases and so does the shareholders’ equity or value in the company. The more the company is worth the more profit shareholders can earn. As that value increase the shareholders can receive a share of the profits referred to as dividends. The purpose of dividends is to return wealth back to the shareholders of a company. This formula for Shareholders’’ Equity is listed below:
Shareholders’ Equity = Total Assets − Total Liabilities
The magic behind the “Rule of 72” is compound interest. Albert Einstein described compound interest as “the most powerful force in the universe”. In summary, compounding interest means earning interest on interest. Each time interest is paid, it is paid on an increasingly larger and larger balance. Compound interest allows your money to work for you. Your money is working for you when your money is earning more money. Money growing more money sounds unreal and makes you wonder when the unicorns and fairies will appear. I bet you are thinking how many rainbows will I have to follow to uncover this pot of gold? I ensure you that money growing money is a real thing. It is called compound interest, and although no fairy dust is required, it is still magical. However, for compound interest to work, it does require you to be willing to invest money and keep investing money over a long period of time. For example, earning 5% interest on $1,000 would result in $50 of interest per year. But with compound interest, it would be $50 the first year, $52.50 the second year (5% of $1,050), $55.13 the third year (5% of $1,102.50), etc.