Tuesday, July 13, 2010

The Rule of 72 in a different light

We previously discussed the the Rule of 72 as a simplified way to find out how long an investment will take to double at a given interest rate. Here’s how it goes:

Divide 72 by the given interest rate and you can find out how many years it will take double your money.

The Rule of 72 also works in another way;  you can find out the exact interest rate or rate of return needed if you wanted to double your money within a certain number of years. You can rework the Rule of 72 like this:

72 ÷ # of years = the rate needed to double your money

Here is an example:

Roger is 16 and he’s saved up $5,000 so far. He figures, he can easily double that amount 6 years, by the time he finishes college.  But  Roger is not sure what type of investment or interest would be needed to achieve that goal. Let’s plug in the numbers to see how this could work...

      72 ÷ 6 (years) = 12 (%)

Solution: In order to double $5,000 in 6 years time, Roger will need to find an investment giving him a compounded annual return of 12%.

Sounds like simple stuff in terms of calculations but we all should consider using this as a gauge when talking with your kids about financial planning. If their time horizon is say 10 years (e.g. until they get out of college) remind them that they will need about 7% of compounded annual return to double their money.   A nice side effect of using the Rule of 72 in conjunction with certain milestones, i.e. Graduating from Middle School, High School or College, is that it gives the kids an objective and a time horizon that they can grasp.  This is possibly more effective than telling them they should save for retirement in 50 years, which is a time frame, even most of us parents are unable to grasp.