The rule of 72

May 20, 2016 | Dian Chaaban

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I met with clients of mine on Tuesday for their annual review and they asked me about the rule of 72. They had heard about it from their 14 year old daughter who was doing a project on Albert Einstein, the genius we all know who discovered the rule (he considered it his greatest discovery even over E=mc2 ) as the most powerful force on earth,

“…compound interest the eighth wonder of the world and mankind’s greatest invention because it is the mightiest force ever unleashed for the amassing of wealth”Albert Einstein

In its simplest form Einstein explained the rule and compounding as earning interest on your capital invested and in the next year, you earn interest on your capital and the interest you earned the year before, and so on and so on. Investopedia defines the Rule of 72 as “a shortcut to estimate the number of years required to double your money at a given annual rate of return. The rule states that you divide the rate, expressed as a percentage, into 72:

Years required to double investment = 72 ÷ compound annual interest rate

*Note that a compound annual return of 8% is plugged into this equation as 8, not 0.08, giving a result of 9 years (not 900).

Let’s take a look at an example of two investors to illustrate this further:

Julia is 30 years old and she invests \$10,000 per year; John is 40 years old and also invests \$10,000 per year. To keep it simple, let’s assume they are both earning a rate of 7.2% on their portfolio (meaning they will double their money every 10 years).

Both Julia and John want to retire at age 60 and start drawing an income from their portfolio…fast-forward a few decades and by age 60, Julia’s portfolio is worth \$1,049,798 while John’s is worth \$449,189. A simple example like this one shows how powerful the force of time IN the market and compounding can be (10 years difference between John and Julia is \$600k!) and the importance of starting to save & invest early.

While the rule of 72 is a useful shortcut, some would argue that it isn’t the ideal calculation because it does not factor in the real impact of inflation on your future purchasing power, assumes that you are earning the same rate each year and that your money is fully invested (and re-invested) for the entire duration. An ideal scenario but not realistic because we have to admit that life doesn’t always go according to plan. So while the calculation is a simple and handy one to give us a quick estimate of what we could expect, much more planning and discipline goes into your long-term financial success.

That said, the best lesson my client’s 14 year old daughter learned from her assignment was to start saving her allowance now to take advantage of the rule of 72 asap (she did the math and realized that her \$20 monthly allowance could be worth ~\$139,000 by the time she retires!).