If you are new to investing you will come across a concept known as "The Rule of 72". What it boils down to is a quick reminder that investment performance, in terms of long term rate of return, is VERY IMPORTANT, but TIME invested is even more important…
The rule of 72 states that 72 divided by your long term rate of return will give you the time in years for your investment to double. Conversely, if you need to figure out the rate of return you need to double your money in a known number of years, you can take 72 and divide it by the number of years.
You expect that your investments will earn an average rate of return of 10%.
72 divided by 10% rate of return = 7.2 years to double your money.
So if you had $10,000 and it earned 10% every year, you would have $20,000 after 7.2 years.
You have $250,000 in your retirement savings account and you would like to retire in 7 years. You have determined that you could comfortably retire if you had $500,000 in your retirement account. In order to double your money from $250,000 to $500,000 in 7 years you could use the rule of 72 to get a rough idea of the rate of return you will need to achieve your goal: 72 divided by 7 years = 10.3. Therefore your investment will need to earn an average rate of return of 10.3% to double in 7 years.
Note that the rule does stray a bit with extreme values – for example if you wanted to double your money every 3 years the rule tells you that you need an annual rate of return of 24%, but if we work through the math you’ll see you get close, but not quite exactly to double…
If you wanted your money to double every 3 years(!), you would use the rule of 72 to calculate: 72 divided by 3 years = 24% annual rate of return.
Year 1 Beginning Investment Value = $100,000
Annual gain of 24% in year 1= $100,000 x 24% = $24,000
Year 2 Beginning Investment Value = $124,000
Annual gain of 24% in year 2 = $124,000 x 24% = $29,760
Year 3 Beginning Value = $153,760
Annual gain of 24% in year 3 = $153,760 x 24% = $36,902.40
Year 3 END Value = $190,662.40
So remember, you can use the Rule of 72 to quickly gauge how long it will take for your money to double if you know the rate of return, OR what rate of return you will need to earn for your money to double in a certain period of time. BUT it is not a hard and fast formula – it is only a rule of thumb.
Why is this important? Well the power of compounding is a serious thing. In fact, Einstein even said it was the most powerful concept he knew of (and this was after he discovered how to split the atom). If you took one thousand dollars, how many times would you need to double it to get to $1 million?
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