The Rule of 72 is a great lesson in how compound interest can increase your wealth. It compliments the concept of the time value of money. However, what many don't tell you is what you need to avoid in order to keep the rule in effect.
The Rule of 72 is more a scenario rather than a rule since other factors need to be constant. The rule states that the number 72 divided by the interest you earn will give you the number of years it takes for a certain amount to double in size. The equation is this:
Let's look at an example Let's say that you have $10,000 and you are earning 4% annually. It will take approximately 18 years for it to double to $20,000.
Keep in mind that amount does not make a difference.
Let's say that you have $30,000 and you are earning 4% annually. It will still take approximately 18 years for it to double to $60,000.
The key here is that if you want to decrease the time it takes to double your money, you need to increase the balance or increase the interest rate (or growth rate).
The rule also works in reverse. Let's say you want to shorten the time span and you want to double your money to 10 years (rather than 18). You will need to earn an interest rate of 7.2 in order to hit your target.
Below is a simple table to show you how long it will approximately take to double a $10,000 investment along with more doubling increments.
|Number of Years||4%||6%||12%|
As you can see, earning interest at 4% percent takes 18 years for it to double, which doesn't give you a lot of time for it to double multiple times. Earning interest at 12% gives you multiple doubling periods in your lifetime.
Here's what they don't tell you
According to the Rule of 72, during the growth years, money is not removed and the interest rate is fixed. These two variables must be constant in order for the rule to work. Now, if more money is deposited or your interest rate increases, you'll hit your target even faster. No one is complaining there.
Could the advantages of whole life insurance be a strategy to ensure effective doubling periords?
Could a policy loan be better than a withdrawal from your bank?
Things change. Things come up. You need to take withdrawals. Markets go up and down...and along with it the interest rates.
Fluctuations in your balance and interest rate will distort the Rule of 72.
Let's look at 401k retirement plans. Even if your plan boasted an average 8% interest rate, that doesn't mean much. You can still experience capital losses within the account. The "average" interest rate that you are earning goes up and down.. Especially today, we know that the 401k ride is one roller coaster of a ride.
So what do you do if this occurs at the tail end of your career? Do you keep pushing retirement further away? Do you get riskier and go for more aggressive investments?
No one tells you how to recover. Maybe no one really knows with certainty. Maybe the solution to this problem isn't to solve it.
Maybe the strategy of putting your money in one basket to do one thing is the problem.
As I said earlier, the Rule of 72 is more of an ideal "scenario" than a rule. Other factors must be in place.
You should definitely keep this rule in mind when making financial decisions. Strategize to shorten that doubling period.
Keep in mind where you money is invested and how volatile its interest rate is. Withdrawals and capital losses will impact the "rule".
Remember, depending on where you invest your money, you could be betting double...or nothing.
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