Applying the Rule Of 72 in finance

Introduction

The Rule of 72 is a handy financial formula that helps investors estimate how long it will take for their investment to double in value at a given fixed annual rate of return. It’s a quick, straightforward calculation that can be useful in making long-term investment decisions without needing complex calculations or financial software.

Understanding the Rule of 72

The Rule of 72 is based on compound interest, the process of earning interest on both the initial principal and the accumulated interest from previous periods. The formula is simple: divide 72 by the annual rate of return (as a percentage) to get the approximate number of years it will take for the investment to double.

Formula:

    Years to double = 72 / Rate of return on investment

For example, if you have an investment with a 6% annual return, you would divide 72 by 6, resulting in approximately 12 years for the investment to double. ​

Why 72?

The Rule of 72 is an approximation rather than an exact calculation, but it’s based on the nature of exponential growth. The number 72 works well because it is divisible by many factors (such as 2, 3, 4, 6, 8, 9, and 12), which makes mental calculations easier. This rule is most accurate for interest rates between 6% and 10%, where compounding closely follows the formula. For higher or lower rates, slight adjustments may be needed, but 72 generally gives a reasonable estimate.

Practical Applications

The Rule of 72 has several practical applications in personal finance and investing:

• Estimating Growth of Investments: If you’re investing in a stock market fund expected to yield around 8% annually, dividing 72 by 8 tells you that your investment should double in about 9 years
• Assessing Inflation Impact: The Rule of 72 can also be used to understand how inflation erodes purchasing power. If inflation is at 3%, dividing 72 by 3 suggests that the value of money will halve in 24 years.
• Loan and Debt Management: It’s also a useful tool for understanding the impact of interest rates on debt. If a credit card has an 18% interest rate, for instance, any unpaid balance could double in 4 years (72 ÷ 18 = 4).

Limitations

While the Rule of 72 is helpful, it’s not exact. For example, at very high or low interest rates, the approximation becomes less accurate. For rates below 6% or above 10%, the estimate can be off by several months or even years. For more precise calculations, a compound interest formula is preferable. Furthermore, the Rule of 72 assumes a fixed rate of return, which doesn’t always apply in real-life investments, where returns can vary.

Adapting the Rule

Some investors use a modified version for more accuracy at different interest rates. For example, at a 1% interest rate, using 69.3 instead of 72 provides a closer estimate. For 20% returns, 76 is sometimes used. However, for most cases, the simplicity of 72 makes it popular.

Conclusion

The Rule of 72 is a versatile and accessible tool for investors, allowing quick mental calculations to estimate investment growth, assess inflation effects, and understand debt growth. While it’s a rough estimate, it remains a valuable method for financial planning and setting realistic expectations in an ever-changing financial landscape. By giving a clearer picture of how investments and debts grow over time, the Rule of 72 can guide better financial decision-making and help investors develop a long-term strategy for wealth accumulation.