Saturday, June 06, 2009

Simple Way to Explain “Rule of 72”

Perhaps the most useful financial formula is the “Rule of 72”. It is a simple way to “estimate” how long it takes to double your money without using the complex financial formula.

However before you even want to know about this rule of 72, the fist thing you want to know is the compound interest. This is due to the fact that, this rule only applicable for your investment that based on the compound interest (which means you reinvest your interest return into your principal).

72 / Interest Rate (p.a.) = Years to Double Your $
Example 1: Investment
How much I can double my investment return of $10k with 8% interest?

Answer 1:
72 / 8% = 9 years.

If you’re now 25 years old, you will have $20k at the age of 34 years old.

Example 2: Inflation
I spend $2k per month. How long that my spending will inflate until $4k with my personal inflation rate of 2%?

Answer 2:
72 / 2% = 36 years.

If you’re now 25 years old and when you’re 61 years old later, you need to have at least $4k for your monthly spending.

Example 3: Goal Setting 
I’m now 30 years old and I have $100k cash now to invest. I want to have $200k in 2 years time. What is investment return that I should get to reach my goal?

Answers 3:
72 / 2 years = 36%

So if you want to earn the extra $100k in 2 years time, your investment return is expected to have at least 36% returns.

Rule of 72 gives you a quick estimation on what my interest rate should be or how many years that I need to double my return. It applies to anything that as long as it is based on the compound interest principle (e.g. inflation, saving, investment and even goal setting). Hope this helps.


Jenny said...

Thanks for the sharing. I like the idea of exponential return of compounding interest. It is really very powerful. Is there a rule of triple? or X4, X5?

ChampDog said...

Yes, there is. Rule of 120 is to triple your return and rule of 144 to X4 your return.

So use the first example:
120/8% = 15 years (X3 of return)

144/8% = 18 years (X4 of return)

Cool, isn't it? It only takes 3 years from X3 -> X4. As you said, this is due to the exponential growth of the compound interest.

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