Show me the money!
If investment had a magic number, it would be 72. Here’s why.
The rule of 72 is used to calculate approximately how many years it will take for an investment to double at a particular rate of return*.
To find out how long it will take to double your investment, divide 72 by the investment’s rate of return.
Doubling Time (number of years) = 72 / Investment Return per annum
To find out what rate of return you need to achieve to double your investment in a certain number of years, dive 72 by the number of years.
Required Investment Return per annum = 72 / Doubling Time (number of years)
What’s the catch?
Generally speaking, when you invest money there is an expectation of a trade off between risk and return. The higher the expected investment return, the greater the risk you are likely to be taking. On the other hand, investments with lower expected returns generally expose you to lower levels of risk. So you may be able to get a higher return on your investment (and double your investment in fewer years) if you are willing to take on more risk.
Don’t we all want to double our investments as quickly as possible? Why doesn’t everyone risk it to get the biscuit?
Everyone is comfortable with different levels of risk. Some people are very comfortable taking high risks in return for higher expected returns. The flipside of this is that while your chances of achieving high returns might be greater, so are your chances of achieving poor or negative returns of a similar (or perhaps greater) level to any gains.
This is why other people are prepared to accept lower expected returns. They don’t like being exposed to higher levels of risk.
What does this look like in real life?
Meet Georgia. She recently received a $5,000 tax refund and is weighing up 3 investment scenarios for these funds. The 3 scenarios have different expected returns, and therefore different amounts of associated risk. As you can see in the table below, the amount of time it takes to double the investment dramatically decreases as the rate of return increases due to the power of compounding.
|Investment||Expected Return (per annum)||Approx. number of years until investment doubles|
|Cash – Low Risk|
|Balanced Portfolio – Medium Risk|
|High Growth Portfolio – Higher Risk|
One of the benefits of the rule of 72 is that it allows for effect of compound interest (year on year growth), rather than just simple interest.
While the difference between a yearly return of 2% versus 3% seems small, the amount of time it would take to double the original $5,000 investment is significant:
- 72 / 2% Investment Return = 36 years to reach $10,000
- 72 / 3% Investment Return = 24 years to reach $10,000
It would take an extra 12 years to double the original investment at 2% return versus at 3% return. This just goes to show the significant effect a small increase in return can have when it comes to growing your money!
A Handy Little Trick!
Using the Rule of 72 to (roughly) show how quickly your savings or investment will grow highlights the time value of money and can help serve as a decision point before committing to one investment strategy or another.
If you’d like to know more about investment, please contact us.
*This rule is not linear and does not hold as rates of return rise.