The Rule of 72 is a quick and easy way for investors to work out how many years it would take an investment to, theoretically, double in value.
Quite simply you divide 72 by the expected rate of return and as quick as flash, you will arrive at an approximation of the answer. It’s a great way to impress friends and family at dinner parties.
Let’s say an investment is expected to return 10% a year. So 72 / 10 = 7.2.
In other words, it would take roughly seven years for the investment to double.
Just to prove that it works:
(1.1 x 1.1 x1.1 x 1.1 x 1.1 x 1.1 x 1.1) = 1.949
So $1 invested at 10% a year would compound to $1.95 in seven years. That’s pretty close to 2.
It also works if you need to estimate how long it would take for a sum of money to halve in value too.
Let’s now assume that the rate of inflation is 5%. And you want to find out how long it would take for your savings to lose half its purchasing power. So 72 / 5 = 14.1.
In other words, a pot of money would only have half of its buying power after 14 years if inflation at a rate of 5% persisted over that period.
Some of the more eagle-eyed amongst you will probably point out that the Rule of 72 doesn’t work well for high rates of returns. And you would be right.
For instance, according to the Rule of 72, an investment that promises a 100% return would only take 0.72 years (or 8-1/2 months) to double, when it should take one year.
Therefore, it is important to appreciate that the Rule of 72 works best for lower rates of returns. For higher rates you are going to have to whip out your calculator or load up your spreadsheet. I wouldn’t be surprised if someone, somewhere has written an app for that.
But all I can say about the limitation of the Rule of 72 is that if someone promises to double your money in one year, then just smile politely, walk away quickly whilst holding onto your wallet or purse tightly.