You’ve probably heard of the “Rule of 72.” This is the basic indicator for calculating how quickly the value of an investment will double.
Most financial metrics are a little too complex to run in your head. To calculate internal rate of return, yield to maturity, or common risk metrics such as beta and standard deviation, you will need a spreadsheet or financial calculator. The advantage of the rule of 72 is that even your average nine-year-old can calculate it.
Let’s take a look at what the Rule of 72 is, how it works, and how it can be used in financial planning.
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What is the Rule of 72 in simple terms?
The Rule of 72 is a simple formula that allows you to easily estimate how long it will take for an investment to double in value, assuming a fixed annual rate of return. This is a powerful tool for estimating the effect of compound interest and can be used to measure the growth potential of an investment over time.
The formula for the Rule of 72 is surprisingly simple. Divide 72 by the annual rate of return you expect to earn from that investment. For example, if you expect an 8% annual rate of return, it will take approximately 9 years for your investment to double (72 divided by 8 is 9).
What is an example of the rule of 72?
More specifically, let’s say you own the S&P 500. index fund And we want to plan for some scenarios. If the index rises at the historical average of about 10%, then the money will double in about 7.2 years (72/10 = 7.2). If he believes that strong earnings are likely to cause the S&P 500 to return, say, 15%, then his money will have doubled in 4.8 years (72/15 = 4.8).And S&P, for example. recession Then your money will double in 14.4 years (72/5 = 14.4).
The rule of 72 can also be used to assess the impact of inflation on purchasing power. If you want to know how long it will take for the purchasing power of money to be halved for reasons such as: inflation , you can use the same formula. Let’s say the inflation rate is 3%. Divide 72 by 3 and you get 24 years. Assuming an inflation rate of 3%, his purchasing power will be cut in half in 24 years.
Why should I use the Rule of 72?
The benefits of the Rule of 72 are clear. This is a simple formula that anyone with elementary school math skills can calculate. No Wharton MBA or CFA Charter required. It also allows you to set realistic expectations for your investments and helps you determine whether your financial goals are achievable within the investment period.
You can also use the Rule of 72 to compare different investment options. For example, let’s say you’re deciding between a stock fund and a fund. bond funds If you have two very different expected returns, the Rule of 72 can help you evaluate which one will help you reach your financial goals faster.
However, keep in mind that the Rule of 72 is designed to be a rough estimate, and its assumptions are not necessarily realistic. Although it assumes a constant rate of return, the return on stocks is never constant. The average return is not indicative of the return you would have received in a given year. It also doesn’t take into account taxes, fees, and other expenses that can eat into your bottom line. And like all financial models, it is only as good as its inputs: garbage in and garbage out.
Although by no means a comprehensive analysis, the Rule of 72 is a useful tool that provides a quick and easy way to estimate how long it will take your investment to potentially double. This can be helpful when comparing financial plans and investment options. Again, this is something that even beginner investors can practice.
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