Investing and the Rule of 72
When it comes to investing, whether you have a stock account, mutual funds, a retirement account or cash, it´s nice to have a general idea of how long it will take you to earn money. Interest earnings are the main component of investment income, and the lower your annual percentage yield, the slower your investment portfolio will build wealth for you. However, there is a "rule´ you can use to help you evaluate how quickly an investment is likely to work for you. It is called the Rule of 72, and it can help you figure compound interest.
What is the Rule of 72?
Basically, the Rule of 72 is a fairly simple way to get an idea of how long it would take your money in a certain investment to double. What you do is take the interest rate and divide it into 72. The result is the approximate number of years it will take your money to double in the investment account. For example:
You have your money in a traditional savings account, earning an annual percentage yield of about 1.63%. So, 72/1.63=44.17. In a regular savings account, it will take you about 44 years to double your money.
Here are some fairly common approximations of other types of investment accounts that can give you an idea of how long it would take you to double your money:
- Online savings account: Average interest rate is 4.5%. 72/4.5=16 years to double your money.
- Money market account: Average annual percentage yield is 5.15%. 72/5.15=13.98 or 14 years to double your money.
- Aggressive mutual fund: Average interest rate is 12%. 72/12=6 years to double your money
- "Safer" mutual fund/Retirement plan has an average annual percentage yield of about 7%. 72/7=10.28 years to double your money
As you might gather, the riskier the investment, the better the interest earnings, and the more quickly you make returns. When you invest in stocks, the interest earnings are a little higher than mutual fund earnings. In some cases, though, they are much higher - even as high as 20% or more. But these are also investments that can plunge dramatically, potentially causing you to lose it all.
How the Rule of 72 adds up
Let´s say you have a steady mutual fund investment for your retirement account (like my Roth IRA). You start it when you are 30, and you open with $500 and arrange to contribute $250 per month. At the end of the first year, you will have $3,500 in your retirement account ($500 initial plus the 12 months x $250). If you didn´t do anything else (which you won´t; you´ll keep adding to it), let´s see how it adds up. Above we see that it takes 10 years to double your money:
- Age 40 = $7,000
- Age 50 = $14,000
- Age 60 = $28,000
- Age 70 = $56,000
- Age 80 = $112,000
As I mentioned, though, you will keep adding money, and so you will be able to amass even more money. And, if you are younger, you should put part of your investment portfolio in more aggressive stocks. So, really, you should have about half in an account with a higher APY when your first start out:
Half to the tamer mutual fund ($250 initial plus $125 per month = $1750 at end of year) and half to aggressive returns at 7% and 12 % respectively. Keep in mind with the aggressive account your money doubles every six years, and with the "safer" account, it is every ten:36 $3500
40 $3500
42 $7,000
48 $14,000
50 $7,000
54 $28,000
60 $14,000 & $56,000
At this point, everything should be moved into something more tame, so you have $70,000. Then: for age 70 = $140,000 and age 80 = $280,000. You can see what a difference it makes.
Note that this happens if you do not contribute to your investment account after the first year. You will keep contributing, so you will always have more money to double as you stagger your interest earnings. And, if you can afford to contribute even $50 more per month, you will do much better.
Rule of 72 disclaimer
It is also worth noting that the Rule of 72 is not right on. It is just helpful to give a general idea of how long it would take to double your money. Most of the interest earnings are average over a number of years, since the annual percentage yield will fluctuate year to year. So that will also tweak the actual earnings a bit. And you should know that once you get into higher annual percentage yield, the Rule of 72 becomes less accurate. It is almost useless once you get to 20% APY.
