The rule of 72 is a simple mathematical formula used in finance as a shortcut to estimate the number of years required to double your money at a given annual rate of return (http://www.investopedia.com/terms/r/rateofreturn.asp). The rule states that you divide the rate, expressed as a percentage, into 72.
For example, take an investment of £100,000. If this is invested over ten years with the aim of doubling to £200,000, then the investment should return 7.2% per year. Hence the rule is 72 = 7.2 x 10.
This rule is not restricted to just 7.2% and 10 years, it also applies in reverse. An investment could equally double if it achieved 10% in just 7.2 years.
It also works for other two number combinations that multiply together to make 72. For example, 8 x 9 = 72 and 6 x 12 = 72. In these two examples, the rule of 72 estimates that an investment would double as follows:
- A return of 8% per year over 9 years or 9% per year over 8 years
- A return of 6% per years over 12 years or 12% per year over 6 years.
Be sure to note that this is an estimate. The best use of this rule is in the discussion, which could be social as well as in a business environment. If someone has a shortfall of £400,000 to achieve a figure to retire, then if an investment return of 7.2% could be attained, an investment of £100,000 would need to double twice over twenty years to bridge the shortfall. The financial adviser just needs to half the target amount to find a need of £200,000 in ten years and a half again to find £100,000 in a further ten years. It’s an estimator to build credibility and aid connection with potential new clients.
I hear your question, ‘Where does 7.2% investment return come from?’ The rule also applies (though less accurate) to 6% over 12 years i.e. 72 = 6 x 12. It hence follows that when Warren Buffet claims (Buffet Says │ Bloomberg via The Simple Dollar) that you should expect a 6 to 7% annual return in the stock market over the long term, he is equally saying that for your investment to double it will take approximately 10 to 12 years. Buffet describes his analysis to that kind of expected annual return as follows:
‘The economy, as measured by gross domestic product, can be expected to grow at an annual rate of about 3% over the long term, and inflation of 2% would push nominal GDP growth to 5%. Stocks will probably rise at about that rate and dividend payments will boost total returns to 6 to 7%.’
So, while the rule of 72 is not accurate, used appropriately, it is a useful tool to enable a financial adviser to express the need for early investment. It helps the adviser to illustrate tangibly the impact that time has on growth, that investment alone will not achieve a client’s expectations, ad that they also need to invest more!
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