Have you heard of the “Rule of 72”? If you consume FI and FIRE content including blogs or podcasts then chances are you have. Nevertheless, I thought it would be helpful to cover this rule today since many have never heard of it, and it has practical use for everyone — especially HENRYs in the pursuit of FI.
What is the Rule of 72:
The Rule of 72 is a very simple way to calculate the number of years it will take to double your money based upon a specific investment return. The formula is quite simply:
Number of Years to Double = 72 / Rate of Return
The Rate of Return is the annual interest rate return on your investments. For example, if you were to assume your investments will return 10% annually, it would take ~ 7 years to double your investment (72/7). When using this formula, you should always express the Rate of Return as a number (e.g. 7) and not as a decimal (e.g. .07).
How to Use the Rule of 72:
As noted above, the Rule of 72 is a quick and easy way to determine the length of time required for your investments to grow. Below is a visual to give you a better appreciation for the growth expectations based upon interest rates between 1%-10%.
I highlighted 7% and 10% because these are two rates of return thrown around often in the FI and FIRE communities. Assuming a 7% rate of return, you can expect your investments to double in ~ 10 years. Assuming a 10% rate of return, you can assume the same doubling of your investments in ~ 7 years which is a full 3 years sooner.
Once you determine which rate of return assumption you want to use, you can extrapolate out your investment growth over whatever time period you want. For example, let’s assume you have $500,000 invested and you want to assume a 7% rate of return. The chart below shows the value of your investments as your money continues to double every 10 years (72/7).
The math is straight forward, but seeing it in this format can be enlightening to say the least. $500,000 invested today at a 7% return would be worth $16,000,000 in 50 years. This is the magic of compound interest and time! The more doubling opportunities that exist in your investing lifetime, the more your assets can grow. Of course it is still important to point out this is ONLY an estimate. It does not factor in inflation, taxes, or fees, nor does it account for the fluctuation of your investments over time — which IS reality. Regardless, it is still a great approximation for determining your investment growth over a period of time.
Treat the Rule of 72 as a Rule of Thumb:
As you would probably suspect, this rule is more of a rule of thumb. Since it is derived from a more complex calculation, it is only an approximation and should be treated as such. If you are looking for a more accurate way to calculate the growth of your investments, you should use a compound interest calculator. I frequently utilize the calculator available here.
Rule of 72 Rate of Return Assumption:
You can utilize any rate of return assumption you wish when using the Rule of 72. The average rate of return for the stock market over the last 100 years has been ~ 10%. [1] The average inflation rate between 1914 and 2021 has been ~ 3%. [2] When accounting for inflation, the net of these two would be 7% which is why you will often see a 7% rate of return utilized for projections. I personally prefer to use a 5% or 6% return when trying to account for inflation. This results in the doubling of your investments every 12 – 14 years when utilizing the Rule of 72. It is important to remember that future rates of return are not guaranteed regardless of past rates of return. In addition, your rate of return is highly impacted by your asset allocation, inflation, and other factors.
Practical Application:
I personally put the Rule of 72 to practical use in several ways:
First, I use the Rule of 72 to get a rough idea of how large my current investments will grow over a specific time period. For example, if I have $1,000,000 in invested assets and assume a 6% real rate of return (9% less 3% inflation), I can estimate that I will have approximately ~ $2,000,000 in ~ 12 years, ~ $4,000,000 in ~ 24 years, and ~ $8,000,000 in ~ 36 years. This in theory would be in today’s dollars since a 3% inflation rate is accounted for. When making decisions, I will utilize a compound interest calculator as noted previously, but the Rule of 72 method gives me a quick and easy way to estimate.
Second, I use the Rule of 72 to quickly evaluate purchases from an opportunity cost perspective. For example, let’s say I am evaluating a new car purchase. I plan to pay cash for the new car and expect to pay around $35,000. Without complicating things by accounting for the difference in maintenance costs, insurance, etc., I can quickly evaluate the opportunity cost of the decision. If I were to invest the $35,000 based upon my IPS (Investor Policy Statement) instead of buying the new car, I can quickly calculate that I will have ~ $70,000 in ~ 12 years (72/6) as a result of forgoing the purchase. From a financial perspective, I seek to save for a better tomorrow while still living my best today so I find this exercise useful for larger purchases that make a real difference financially.
Conclusion:
As you can see, the Rule of 72 can be great tool in your financial toolbox to estimate growth based upon a rate of return assumption. It has practical use for everyone, but especially those in the pursuit of FI.
Regards,
Henry
Note: The information published in this post is for informational and entertainment purposes only, and does not constitute accounting, tax, investing, or other professional advice. All examples provided were for entertainment and illustrative purposes only. Readers should not take action on any information within this post. Readers should instead seek advice from a tax or investment professional where appropriate.
References:
[1] https://www.nerdwallet.com/article/investing/average-stock-market-return#:~:text=The%20average%20stock%20market%20return%20is%20about%2010%25%20per%20year,for%20annual%20stock%20market%20returns.
[2] https://tradingeconomics.com/united-states/inflation-cpi#:~:text=Inflation%20Rate%20in%20the%20United,percent%20in%20June%20of%201921.
*** All photos credited to Unsplash.com