The Rule of 72

    

The Consummate Capitalist uses the Rule of 72 as a very easy mental short-cut to quickly get a gauge of how long a proposed investment would take to double in value.  Simply divide 72 by the annual rate of return (expressed as a whole number) that will be realized; and the result is the approximate number of years that it will take for the doubling effect. For example, if a bank C.D. will earn 4% annually, then divide 72 by 4. The result, 18, is the approximate number of years that will elapse before the C.D. will double in value.  Alternatively, if a business is growing its operating profits by 9% annually, divide 72 by 9 and the resulting 8 stands for approximately 8 years to double the operating profits. The Rule is meant to be used as a very quick way to make "on the fly" financial calculations: it does not provide the exact answer.

By pulling out a calculator with an exponent function, you can convert your approximate, short-cut answer into a very precise answer.  The formula is: FV = PV(1+i)ⁿ , where

FV= future value of the investment;

PV= present value of the investment (your starting principal or invested amount);

i = the annual interest rate (rate of return);

n= the number of years the investment is held

Example: if you invested $10,000 in the mutual fund referenced above:

      FV = $10,000(1+.09)⁸

      FV = $10,000(1.9925)

      FV = $19,925.62

The formula’s result shows that the investment almost doubles in 8 years; by trial and error you can determine that 1.09 to the power of 8.1 actually derives the necessary answer of 2.0 for the doubling effect. To the see the efficacy of the Rule of 72, you can see that the Rule’s quick mental shortcut gave 8 years, where the exact calculation was 8.1 years. For most investors, the Rule provides an excellent way to compare competing investments’ returns before delving into all the complicating matters, such as taxes and inflation.

 

---

Comments

If you would like to comment on the above Financial Editorial, Click Here!