Learn the popular Rule of 72, and master its application in the world of investing

The Rule of 72 is a simple, widely-used formula to estimate how long it will take for an investment to double, given a fixed annual rate of return. By dividing 72 by the interest rate (expressed as a percentage), investors can quickly calculate the approximate number of years it will take for their money to double.

Rule of 72 Formule

Years to Double = 72/Annual Interest Rate

For example, if you have an investment with an annual return of 8%, you can estimate the doubling time as:
Years to Double = 72/8 = 9 years
This means that with an 8% annual return, it will take roughly 9 years for your investment to double.

Origins of the Rule of 72

The Rule of 72 is a mathematical approximation derived from logarithms, though you don’t need to be a mathematician to use it. The formula is based on the concept of compound interest, which is when the returns on an investment are reinvested to generate more returns over time.

Compound interest grows faster than simple interest, and this rule captures that exponential growth. The "72" comes from natural logarithms, where the base of natural logs (approximately 2.71828) and the nature of compounding are used to derive the constant value of 72. This is an approximation, but for interest rates between 6% and 10%, it works remarkably well.

How to Use the Rule of 72 in Investment

Investors use the Rule of 72 as a quick, mental math tool to assess how long their investments will grow or to compare different investment options. It’s especially useful when comparing returns on various savings accounts, unit trust (mutual funds), or other investment vehicles.

1. Estimating Doubling Time

The Rule of 72 helps investors quickly estimate how long it will take for an investment to double in value. For example, if you invest in a stock or fund expected to return 6% per year, dividing 72 by 6 tells you that your investment will double in approximately 12 years.

2. Comparing Interest Rates

If you’re considering different investment options with varying interest rates, the Rule of 72 allows you to compare how quickly each option could double your money. For example, an investment with a 10% return will double in 7.2 years (72/10), while one with a 5% return will take about 14.4 years (72/5).

3. Inflation’s Impact

The Rule of 72 can also help you understand how inflation erodes purchasing power. For example, if inflation is at 3% per year, the Rule of 72 tells you that the value of money will halve in about 24 years (72/3), highlighting the importance of earning a return on your investments that outpaces inflation.

4. Understanding Debt Growth

The rule can also be used in reverse to understand how quickly debt, such as credit card balances, can double. If a credit card has an interest rate of 18%, dividing 72 by 18 shows that unpaid debt could double in just 4 years.

Limitations of the Rule of 72

While the Rule of 72 is handy, it's not perfectly accurate for all interest rates or situations:

• It works best with annual compounding and interest rates between 6% and 10%. For very high or very low rates, the accuracy diminishes
• It assumes a constant rate of return, which is not always the case in real-world investments where returns can fluctuate
• For non-annual compounding periods (like monthly or quarterly), the Rule of 72 can still be used, but the estimate becomes less precise.

Conclusion

The Rule of 72 is a quick, intuitive way to estimate how long it will take for an investment to double, given a specific interest rate. While not perfectly accurate, it’s a useful tool for investors looking to compare potential investments, understand the impact of inflation, or recognize the dangers of high-interest debt. Understanding this rule can provide valuable insight into how compound interest works and aid in making informed financial decisions.