Here’s a quick little tip of for planning your investments.
Suppose I have a little bit of money to invest. What interest rate do I need to average to double my money over a period of time?
There’s a neat little trick for roughly estimating this.
The “Rule of 72″![rule of 72]( "rule of 72")
What is the rule of 72? Essentially it states that if you divide your interest rate into 72, you will get the number of years it will take to double your money.
So let’s say I’m investing in a very safe investment that is giving me about 4% interest on average. That means it will take about 18 years (72 divided by 4) for my investment to double. So if I invested $50,000 at 4% in 18 years I would have about $100,000.
Now let’s say I decide to take on a little more risk and invest in something that gives me about 8%. By increasing the risk I’m taking and getting a little better return, my money will now double in only 9 years. This has a compounding effect so over those same 18 years my $50,000 investment would have doubled after 9 years to $100,000 and then over the next 9 years that total would have doubled again. So at 8% interest over 18 years my $50,000 turns into $200,000. I doubled the interest rate but over time I actually quadrupled my money.
Now let’s say I invest in a good mutual fund that averages about 12% over time. Now my money would double in just 6 years. So over that same 18 year period, I would have $100,000 after 6 years, $200,000 after 12 years, and $400,000 after 18 years. I tripled my interest rate, but my investment grew by 8 times from $50,000 to $400,000.
What this really illustrates is the tremendous effect that compounding interest has when taken over a period of many years.
Another use for the “Rule of 72″
There is another use for the Rule of 72 approaching it from the opposite direction.
We all know the bite that inflation takes out of our wallet from year to year. How do you tell exactly how big that bite is? You can use the Rule of 72 in reverse to figure this out.
The problem with inflation is that as each year passes we can’t buy the same amount of stuff with the same amount of money. If my income doesn’t go up, then I know that next year I won’t be able to afford to buy quite as much as I did this year. You can use the rule of 72 to determine how many years it takes for my buying power to be cut in half.
So let’s say that inflation is 3%. That means that in 24 years (72 divided by 3) I will only be able to buy about half as much as I can today. If inflation goes up to 4% then in 18 years my buying power will be cut in half.
One place this is particularly useful is when planning retirement. Let’s say inflation stays steady around 4% and I retire at age 65. That means to maintain the same ability to buy things I will need to have about twice as much yearly income by age 83 (18 years later).
A useful long-term planning tool
The Rule of 72 isn’t perfectly accurate. (Actually, to be more accurate it should be the Rule of 69.3) But 72 gives a fairly close estimate and works nicely because 72 is divisible by so many numbers.
This little trick can provide you with a very simple method to plan your investments to determine how much and what interest rate you need to get in order to have the amount of money you would like to have for your long-term goals like retirement or college planning. And you can also use it to plan for how much that investment needs to grow to cover the damage done by inflation.
Do you have a long-term investment plan for retirement? Are you on track?
Photo credit: byJoeLodge (Creative Commons)