How Does the Rule of 72 Work?
Whether you already have a retirement nest egg or are considering an investment, the Rule of 72 can give you some idea of how fast your money will grow over time. Many financial advisors use this rule to help their clients understand the returns that they may get from a certain investment.
If you are looking for a quick, practical way to see how long it can take for your money to double, the Rule of 72 is highly useful. However, just as with other rules of thumb in finance, it’s only a back-of-envelope formula.
There are some limits to the Rule of 72, and it also assumes that you will get a certain average rate of return each year. Of course, financial markets don’t work that way, so any investment won’t have the same growth rate each year. For those near or in retirement, there is also the potential hazard of sequence of returns risk having an impact on how much money they might have for lifelong retirement income.
In this article, we will go over what the Rule of 72 is, how it works, and how you can put it to good use in your retirement planning and investments in general.
What Is the Rule of 72?
The Rule of 72 is a simple calculation that shows how long it will take for your money to double at a given rate of return. Of course, the higher the rate of return, the less time it will take for your investment to double in value.
How Does the Rule of 72 Work?
Say you have $50,000 and you are thinking about investing it. You might put this money into either a stock mutual fund or a bank CD. You can use the Rule of 72 to figure out how long it will take for your money to double in value.
Simply divide 72 by the rate of growth for that asset, and the result is the amount of time that it will take for your money to double. So, say that the CD would earn 4% per year and the mutual fund 9% per year. We will go over how the Rule of 72 applies to each of these options next.
How Do You Calculate the Rule of 72?
Using the previous example, if the stock mutual fund has grown by an average of 9% per year for the past 15 years, then 72/9 = 8 years. Therefore, your investment would double in value every 8 years, if the fund continues to grow at that rate for the next 8 years (which is by no means a given).
For the CD, let’s say it’s going to pay 4% interest for the next 20 years. The Rule of 72 dictates that 72/4 = 18 years. Your money will therefore double every 18 years.
When Should You Use the Rule of 72?
The Rule of 72 is a handy tool that you can use to estimate the growth of your money. If you are planning for retirement, the rule can give you some idea of how long it will take for your retirement account to double in value.
Of course, some investments in your retirement plan will undoubtedly grow at a faster rate than others. Because of that, you may break your retirement account down into separate segments for more specific estimates.
For example, you could use one growth rate for stocks and/or equity mutual funds, and another growth rate for bonds and bond funds. Then you could apply the Rule of 72 to each of those areas to find out how long it will take your entire portfolio to double in value.
The Rule of 72 in Retirement Planning and Not Going Backwards
Of course, the actual returns you get from your retirement portfolio can drop in value as well as rise. The sequence of returns principle also applies here in addition to the Rule of 72.
If you see a major loss in your retirement investments right when you retire, you may have a big impact on your retirement lifestyle from that point on. This is where lower-risk assets can help balance out that risk and help you preserve funds at this crucial point.
Fixed index annuities are one such instrument. They can allow you to “beat the bank” and earn interest on your money while guarding your principal from market losses. A fixed index annuity can also pay you a guaranteed income stream for life, just as other annuities can do, and help you sustain your lifestyle in retirement.
Fixed indexed annuities also have value in their ability to earn compound interest on the interest they have already earned. Once a fixed index annuity has been credited interest earnings, the interest is effectively locked into the contract value.
Pros and Cons of the Rule of 72
The main advantage to the Rule of 72 is you at least get a general idea of how long it will take for your funds to double in value. But the Rule of 72 also comes with some limits, especially when you are dealing with stock market investments.
While a given stock fund may post an average annual return, such as 9%, the key word here is average. Most stock funds decline in value at some point, and that will throw the Rule of 72 off track somewhat.
As mentioned previously, the sequence of returns must be included when you are projecting your retirement income. A huge loss at the start can throw your retirement plan off balance, as all the subsequent gains and losses will then be based on a much smaller number.
If the growth rate of an investment varies wildly over time, then the Rule of 72 can become quite inaccurate. What’s more, the Rule of 72 typically applies best to growth rates between 6 and 10 percent annually. Rates of return above or below this amount are too subject to change for the formula to be useful.
Finally, the Rule of 72 also assumes that all investment earnings are reinvested into the investment, which doesn’t always happen. It’s good to keep that in mind when you make growth projections based on this rule.
For example, say you want to estimate how long it will take for your dividend-paying stock fund to double in value. You might add an extra year onto the expected timeline for doubling according to the Rule of 72.
If your fund has posted an average annual total return of 9% per year, then it could double in value in eight years. So, here you would add another year on to be on the safe side in your calculation.
The Bottom Line on the Rule of 72
In short, the Rule of 72 is merely a tool for estimating potential growth. But this rule can be broken by many different factors, including sequence of returns and its unpredictable occurrences.
The Rule of 72 shouldn’t be seen as a type of guarantee, because in financial markets, investments don’t grow according to rules. They will perform in accordance with how markets and the economy do.
If you are planning for retirement and estimating future retirement account values, the Rule of 72 can be useful, but it’s just one starting point. Consult your financial advisor for more information on the Rule of 72 and how it can benefit you.
Are you looking for someone to help with your retirement overall? You might want to look for someone who understands the unique nuances of retirement, income planning, and whose business model is independent of any one primary or parent financial company.
If that sounds like a good fit for your situation, many independent and retirement-focused financial professionals are available at SafeMoney.com that can assist you. You can get started by visiting our “Find a Financial Professional” section to connect with someone directly and discuss your goals, concerns, and financial situation. Should you need a personal referral, please call us at 877.476.9723.