Let’s have some fun with the rule of 72.
One of the best things I learned in college was from my Introduction to Macroeconomics teacher. I don’t remember my professor’s name, but she was from Germany and spoke in a heavy German accent. Anyways, one of the most important things she taught me was The Rule of 72.
It is especially helpful for thinking about the future value of investments and doing quick calculations. It’s also a fun party trick.
What is the Rule of 72?
The Rule of 72 basically states that you can take 72 divided by whatever return % you expect, and it will return the time it takes to double your money. As Algebra works, you could also take 72 divided by the # of years you want your money to double and get the interest rate you need to make it work.
It’s a simple formula, so it doesn’t take into account additional cash flows (positive or negative). Although it doesn’t know I’m planning to continue contributing more money to my investments, I still find it extremely helpful.
Here’s an example. Let’s say that I have $10,000 to invest, and I expect to earn 8% interest. I can take 72 divided by 8, and assume that my money will double every 9 years. This means I will have $20,000 in 9 years, $40,000 in 18 years, $80,000 in 27 years and so on.
I created the chart below to show how The Rule of 72 looks with different interest rates in practice. If you have 25-40 years until you retire, you can realistically expect an index fund investment to be worth 8-16 times as much when you retire, again without adding a dime over that time.
I generally estimate a long-term return of around 6% or 7% to be conservative. This means my investments should hopefully double around every 10 years.
I say hopefully because the market doesn’t go up at a steady rate of 7%. It might be up 20% one year, up 5% the next year, and down 10% the following year, but the overall historical trend has been up. This volatility is why it is generally recommended to start transitioning to more conservative assets as you get closer to retirement.
Use the Rule of 72 to Spend Less
This rule helps me avoid impulse spending, which is critical to growing wealth. When I see something that I want, but definitely don’t need, I double, quadruple, or octuple the price in my head.
With little things, this is a fun inside joke my wife and I have, but it really does help. Let’s say I see a new blender, like a Vitamix that I’ve wanted since I was 7. They were 400 dollars last I checked. We have a Ninja that does pretty much what we want, but oh what fun it would be to be like the Vitamix guy at the fair.
If I think about the opportunity cost of that 400 dollars, it is worth $800 in 10 years, $1600 in 20, $3200 in 30. On the other hand, the blender will probably be worth less than $400 in 30 years despite a great warranty. $3200 seems like it might be awfully nice to have when my daughters are getting married.
Perhaps I will be able to give them a Vitamix and $2800, so they don’t have to have this dilemma. Then I could use it whenever I visit. Brilliant!
It even works for smaller items; do I need that $30 shirt that will probably be at Goodwill in a few years? Instead I could have $120 in 20 years. Yeah, I guess I have enough shirts.
A Bit on Saving vs Investing
While saving is an important personal finance principle, savings are meant to protect you, not to grow your wealth.
Unless you are making 6 figures, it will be extremely difficult to reach your financial goals without investing. If you are just putting your money in checking or savings accounts earning below 2% interest, you will need to save $500,000 to $1,000,000 over the course of your money earning years to retire as a millionaire.
However if you are invested and earning even 5-8% per year, you would need to set aside $100,000 to $300,000 over the course of your career (assuming you start somewhat early in your career).
Let’s pretend you have $100,000 to do something with as a 30 year old and 36 years until you plan to retire at 36. To solve this, find all the 36’s in the chart above.
I’ve included them below. You can see the impact interest rates have on your expected return over the long-term.
The Power of Time
This really illustrates how valuable it is to start investing early. That extra 10 years sitting in an investment account can double your money from $500,000 to a $1 million.
Here’s an interesting thought. The average cost of a 4 year degree is $50,000-$100,000, maybe more. If you invested that $75,000 in an index fund when you were 20 years old, you could expect to someday retire with $1-4 million without contributing another dime.
Please Note – I’m not suggesting you do this. A college degree is extremely valuable in its own right. Don’t invest with debt. Don’t drop out of college and invest the money your parents are contributing.
Just something to think about.