THE RULE OF 72: A SIMPLE SHORTCUT TO SMARTER FINANCIAL PLANNING
In the world of finance, where complex formulas and jargon often dominate, the Rule of 72 is one of our favourites and stands out as a refreshingly simple yet powerful tool. Whether you’re a seasoned investor or just beginning your financial journey, this mental math shortcut can help you quickly estimate how long it will take for your money to double—without reaching for a calculator.
What Is the Rule of 72?
At its core, the Rule of 72 is a formula used to estimate the number of years required to double an investment at a fixed annual rate of return. The math is straightforward: divide 72 by the annual interest rate or annual return on your investment (expressed as a whole number, not a decimal), and the result is the approximate number of years it will take for your investment to double.
For example, if your investment earns a 6% annual return, the Rule of 72 tells you it will take you about 12 years (72 ÷ 6 = 12) to double the value of your investment. If the investment earned a 9% return, then the Rule tells you that the value of your investment will double in 8 years (72 ÷ 9 = 8).
Why It Matters
The Rule of 72 isn’t just a party trick for finance nerds—it’s a practical tool for making informed decisions. It helps investors visualize the power of compounding, how to compare investment options, and understand the long-term impact of inflation or debt.
Let’s say you’re evaluating two investment opportunities: one offers a 4% return, and the other 10%. Using the Rule of 72, you’ll see that the first will double your money in 18 years, while the second does it in just over 7. That’s a compelling difference, especially when planning for retirement or long-term goals.
At Magwitch we use it when determining our investment expectations. If we look at the long-term real asset class returns in South Africa we see that the various asset classes have, over the long term, delivered the following inflation beating returns:
(The real returns above are the actual returns less inflation).
If we assume an inflation rate of 6% in South Africa, then the long-term returns of equities of 14.4% would mean that an investment would double every 5 years. Cash on the other hand delivering just 6.9% would require in excess of 10 years to double.
Doubling is a great way to explain compounding when discussing investments. That is because doubling is exponential in growth because 1 doubles to 2; 2 doubles to 4; 4 to 8; 8 to 16; 62 to 32; etc.
We are reminded of a few quotes from Albert Einstein:
Anyone who has never made a mistake has never tried anything new.”
“I have no special talents. I am only passionately curious.”
However, the most famous quote attributed to Albert Einstein about compounding is: “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
While there’s some debate about the exact origin of the quote, it’s widely associated with Einstein due to his known admiration for the power of compounding, particularly in the context of financial investments.
This quote highlights the core concept of compounding: interest earned on both the initial principal and the accumulated interest over time.
Back to our story on the rule of 72
If an equity investment is doubling every 5 years, a starting balance of R1m will grow to R256m over 40 years. 40 years is a great number to consider as that is the length of the average working career and would represent the average investment term for many investors through their retirement savings. The problem with this example is that most people would not have R1m to start with. Perhaps a more practical example would be if you started with R10 000 and invested in a 100% equity fund, this investment would grow to R2 560 000 over the 40 year period. The unfortunate reality though is that most people don’t stick with their investment for such a long time and don’t experience the full benefit of doubling. The longer you remain invested, the bigger the compounding.
Beyond Investments: Inflation and Debt
The Rule of 72 isn’t limited to investments. It can also be used to understand how inflation erodes purchasing power. If inflation averages 6% annually, your money will lose half its value in 12 years (72 ÷ 6 = 12). This insight underscores the importance of investing in assets that produce a return that outpaces inflation.
Similarly, the rule can be applied to debt. If you carry a credit card balance with a 24% interest rate and make no payments, your debt will double in just 3 years. That’s a sobering reminder of how quickly high-interest debt can spiral out of control.
(Remember those that don’t understand the power of compounding pay it)
A Brief History
The Rule of 72 dates back to the 15th century, with early references found in the work of Italian mathematician Luca Pacioli. While the exact origin is unclear, the rule has stood the test of time due to its simplicity and utility. Mathematically, it’s derived from the natural logarithm of 2 (approximately 0.693), which is the basis for calculating doubling time in exponential growth.
Limitations and Variations
While the Rule of 72 is a handy approximation, it’s not perfect. Its accuracy diminishes at very high or very low interest rates. For continuous compounding, the Rule of 69.3 is more precise, and for lower rates, some prefer using 70 instead of 72. Still, for most everyday financial decisions, the Rule of 72 strikes a practical balance between simplicity and accuracy.
Final Thoughts
In a world where financial literacy is more important than ever, the Rule of 72 offers a quick and intuitive way to grasp the power of compounding. It empowers individuals to make smarter choices about saving, investing, and borrowing. So, the next time you’re weighing an investment or wondering how inflation might affect your future, remember this simple rule—and let it guide you toward better financial outcomes. Make sure you understand how compounding works, invest in the correct assets classes and stay with it this process will ultimately give you the best returns over the long run.
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