What Is the Rule of 72? An Introduction For Investors
When it comes to saving for retirement, the power of compounding interest should never be underestimated. And as a responsible investor, it can be helpful to know how long it would take to double your investment at a fixed rate of return. The Rule of 72 can be used as a quick rule of thumb to help determine this answer.
What Is the Rule of 72?
The Rule of 72 is a formula that estimates the amount of time it will take for an investment to double in value when earning a fixed annual rate of return.
72 / interest rate = years to double
Divide 72 by the annual rate of return. This should give you an idea of many years you can expect it to take for your investment to double in value.
It’s important to note that this is not an exact science, and there are scenarios in which a different formula may provide a more accurate answer.
How Does the Rule of 72 Work?
As an example, say someone invests $50,000 in a mutual fund with an estimated annual six percent rate of return.
If we used the Rule of 72, the formula would appear as:
72 / 6 = 12
Based on this formula, the investor may expect their original investment to be worth $100,000 in around 12 years.
Use this estimation method to better understand the effects of compound interest on your investment dollars.
Determine Compound Interest
The Rule of 72 can also be used to estimate how much compound interest your investment has already earned. For example, say you invested $25,000 and it took 10 years to grow to $50,000. You can rearrange the formula to determine your average rate of return throughout those 10 years.
In this case, the formula would appear as:
72 / 10 = 7.2
In this example, your average rate of return was 7.2 percent.
Considerations for the Rule of 72
Before using this formula in the real world, there are a few important considerations to keep in mind.
It’s an Estimation Only
The Rule of 72 can help provide a general estimation, but it is not precise or perfect. Past performance of the market does not guarantee future returns. Therefore, while you can guess an average rate of return based on market performance or other benchmarks, there is no guarantee.
Precision Is Limited
Additionally, studies have found that the Rule of 72 tends to work best for average rates of return between six percent and 10 percent.1 Outside of this window, a more precise formula may be required.
Best for Long-Term Investors
If you’re nearing retirement, you’ll likely want a very precise picture of what your income and savings will look like. This is crucial to identifying potential income gaps and developing a tax-efficient withdrawal plan. Because of this, broad estimations like the Rule of 72 may not be suitable for your needs. Additionally, shorter periods of time before retirement include less space for market corrections should a downturn occur.
The Rule of 72 is a simple, helpful tool that investors can use to estimate how long an investment with a fixed rate of return may take to double. Following this formula can allow you to quickly gauge the potential future value of your investment - although performance is never guaranteed. While you can quickly get an estimate using the Rule of 72, work with a trusted financial professional when making decisions that can affect your portfolio.