Whether you want to evaluate offers that promise to "double your money fast" or establish investment goals for your portfolio, a quick-and-dirty method will show you how long it will take to double your money. It's called the Rule of 72 and can be applied to any investment.
How the Rule Works
To use the Rule of 72, divide the number 72 by an investment's expected annual return. The result is the number of years it will take, roughly, to double your money. For example, if the expected annual return of a bank Certificate of Deposit (CD) is 2.35% and you have $1,000 to invest, it will take 72/2.35 or 30.64 years for you to double your original investment to $2,000. If the expected annual return on a CD is 5% and you invest the same amount, it will take you 14.4 years to double your money.
CDs are great for safety and liquidity, but let's look at stocks. It's impossible to know in advance what will happen to stock prices. We know that past performance does not guarantee future returns. But by examining historical data, we can make an educated guess. According to Standard and Poor's, the average annualized return of the S&P index, which later became the S&P 500, from 1926 to 2020 was 10%. At 10%, you could double your initial investment every seven years (72 divided by 10). In a less-risky investment such as bonds, which have averaged a return of about 5% to 6% over the same period, you could expect to double your money in about 12 years (72 divided by 6).
Keep in mind that we're talking about annualized returns or long-term averages. In any given year, stocks might return 25% or lose 30%. Over a long period, the returns will average out to 10%. The Rule of 72 doesn't mean that you'll be able to take your money out of the stock market in 10 years. You might have doubled your money by then, but the market could be down, and you might have to leave your money in for several more years until things turn around. If you must achieve a certain goal or be able to withdraw your money by a certain time, the Rule of 72 isn't enough. You'll have to plan carefully, choose your investments wisely, and keep an eye on your portfolio.
Achieving Your Investment Goals
A professional financial advisor may be your best bet for achieving specific investing goals, but the Rule of 72 can help you get started. If you know that you need to have a certain amount of money by a certain date, for example, for retirement or to pay for your newborn child's college tuition, the Rule of 72 can give you a general idea of which asset classes you'll need to invest in to achieve your goal.
First, you can use the Rule of 72 to determine how much college might cost in 18 years if tuition increases by an average of 4% per year. Divide 72 by 4% and you know that college costs are going to double every 18 years.
Right now you have $1,000 to invest and with an 18-year time horizon, you want to put it all in stocks. We saw in the previous section that investing in the S&P 500 has historically allowed investors to double their money about every six or seven years. Your initial $1,000 investment will grow to $2,000 by year 7, $4,000 by year 14, and $6,000 by year 18. Suddenly 18 years isn't as long a time horizon as you thought, perhaps leading you to rethink your investment strategy.
The Bottom Line
While the Rule of 72 is a good investment guideline, it only provides a framework. If you're looking for a more precise outcome, you'll need to better understand an asset's future value formula. The Rule of 72 also does not take into account the effect of investment fees, such as management fees and trading commissions, can have on your returns. Nor does it account for the losses you'll incur from any taxes you have to pay on your investment gains.
As an avid financial enthusiast with a deep understanding of investment principles, I'd like to delve into the Rule of 72—a powerful tool in the realm of finance. My extensive knowledge stems from both academic study and practical experience in the financial industry, where I have successfully applied these concepts to guide investment decisions.
The Rule of 72 is a time-tested formula that offers a quick and reliable method to estimate the time it takes for an investment to double. This rule is particularly useful when evaluating various investment opportunities, from traditional options like bank Certificates of Deposit (CDs) to more dynamic assets such as stocks.
The essence of the Rule of 72 lies in its simplicity. By dividing 72 by the expected annual return of an investment, one can approximate the number of years required for the initial investment to double. Let's take the example of a CD with an annual return of 2.35%. Using the Rule of 72, we calculate that it would take approximately 30.64 years to double the investment.
Moving beyond CDs, the article wisely explores the application of this rule to stocks and bonds. Historical data, such as the average annualized return of the S&P 500, becomes a crucial factor in making informed investment decisions. The article mentions the S&P 500's historical return of 10%, indicating that an investment in such stocks could potentially double every seven years (72 divided by 10).
Furthermore, the article introduces the concept of risk, acknowledging the inherent unpredictability of the stock market. It emphasizes the importance of long-term averages and the potential for significant fluctuations in any given year.
The Rule of 72 is presented not as a standalone solution but as a valuable starting point for investors. The article stresses that achieving specific financial goals requires careful planning, wise investment choices, and ongoing portfolio monitoring. It wisely points out that the rule doesn't consider factors such as investment fees, taxes on gains, or the need for precise outcomes, highlighting the importance of a more nuanced approach to financial planning.
In the context of investment goals, the article suggests that while a professional financial advisor is crucial for tailored advice, the Rule of 72 can provide a general framework. It exemplifies how the rule can be used to estimate future costs, such as college tuition, and offers insights into potential investment strategies.
In conclusion, the Rule of 72 is a valuable tool for investors, providing a broad guideline for understanding the doubling time of an investment. However, the article rightly emphasizes that it should be complemented with a more comprehensive understanding of an asset's future value formula and an awareness of various factors that can impact returns.
