THE Rule of 72 is a mathematical formula that is used to estimate the number of years money takes to double at a specified rate of interest or return. How does this formula works? If you are earning six per cent per year on your investments, divide 72 by 6 and the answer will tell how many years your money will take to double.
Investing $1,000,000 at six per cent per year means that the investment will take 12 years to double. The one million dollars invested at six per cent per year will become $2,000,000 in 12 years. Understanding how the Rule of 72 works helps investors to plan for the future.
The impact on retirement
If you are 36 years away from retirement and you invest $100,000 today at three per cent per year, then your $100,000 will double every 24 years. Therefore, at age 65 your $100,000 will be valued at approximately $294,000. However, if you are earning 12 per cent per year on your $100,000 then, at retirement your investment value would be approximately $7,359,000 as your money would double every six years during the 36 years. This is the wonder of compound interest. It's best to project future values of investments using average rates of return, as interest rates or investment returns may change over time, as well as there may be changes in the rate of inflation which will affect the future value of your investments. The Rule of 72 is a useful guide in determining how to invest funds that will give higher rates of return to beat inflation over the long term. Near-retirees take fewer risks, as the concern is to secure the retirement income target. This shows why it is important to start the investment journey early to ensure that funds have time to double many times before retirement.
Investing in higher-yielding investments will pay handsome returns for the investor who invested early during their work life in high-yielding investments such as stocks. The Rule of 72 helps in the diversification of investments. How much of your money should be invested in bonds vs stocks? The decision is influenced by your age, goal, and appetite for risk. Low-risk investments such as bonds offer lower rates of return on investments than stocks, which offers higher average rates of return on investment over time. Investment in stocks at an average growth rate of 12 per cent will see funds doubling faster than an investment in bonds at six per cent over the long term. At six per cent, the bond investment will double in 12 years while a 12 per cent return on stocks will see funds doubling in six years. Stocks will always outperform bonds and other low risks investments in the long term.
The Rule of 72 can also be used to show how many years inflation takes to reduce the value of your money. In Jamaica, the current inflation rate is 10.9 per cent. Using the Rule of 72, we divide 72 by 11 (rounding off). It will take approximately 6.5 years for money available now to lose half its value or purchasing power. The Rule of 72 underscores the debilitating effect of inflation on investments. Double-digit inflation is not expected to be prolonged over the long term as the Bank of Jamaica's annual inflation target is four to six per cent, which has proven a challenge to attain. The impact of inflation on investments and retirement income, in particular, demonstrates the importance of having stocks in your portfolio of investments. It has proven to beat inflation in the long term. Investors should be aware that the performance of stocks should not be assessed based on a moment in time or a particular year's performance but rather the performance over seven years and longer. Inflation is a silent thief and appears as a thief in the night robbing the purchasing power of the value of assets and many investors are caught unaware. Money invested in the right stocks will grow exponentially over time due to the power of compound interest.
Impact on debt
Regarding debts, the Rule of 72 can work against you. For example, if the interest earned on your credit card is 36 per cent, divide 72 by 36, and with the balance remaining unpaid, it will take two years for the money owed to the credit card company to double. This unpaid debt would double every two years. The higher the interest rates the greater the debt owed to the credit card company. The Rule of 72 is a formula that every investor needs to know.
Grace G McLean is financial advisor at BPM Financial Limited. Contact her at: gmclean@bpmfinancial, and visit the website: www.bpmfinancial.com. She is also a podcaster for Living Above Self. E-mail her at email@example.com