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What Is the Rule of 72 in Finance?
For investors, the rule of 72 can be a helpful tool that provides an idea of how long it will take for an investment to double in value, if the annual rate of return is known to be certain or highly probable.
The rule of 72 as such is helpful as a quick approximation tool.
Rule of 72 Formula
The rule of 72 has a basic formula. Simply divide 72 by the expected average rate of return or interest rate anticipated on an investment.
Years Until Investment Doubles In Value ≈
72 / Expected Avg. Rate of Return
For example, an investor who assumes an 8% return on investment, are likely to approximately double their investment in 9 years: (72/8 = 9).
Using the Rule of 72
Let's look at three ways that someone might use the rule of 72.
1. Estimate How Long It'll Take An Investment to Double
The rule of 72 is a quick and easy way to estimate how long it will take an investment to double, but it's not perfect. The actual length of time it takes for an investment to double can be affected by a number of factors, including:
- Volatility of returns
- Inflation
- Fees
However, the rule can be applied to anything that grows at a compounded rate. This means that it can be used to predict the growth in for example, the population of a country, over a number of years.
2. Estimate Long-Term Effects of Interest or Fees
Another use for the rule is to demonstrate, or estimate, the long-term effects of interest on a loan. Many people underestimate the impact that interest has on loans as the balance due continues to grow over time. This applies to business loans, personal loans, and even credit cards. Having this information could help consumers better understand the true long terms costs of borrowing money.
3. Relate Inflation To Dollar Value
Professors sometimes use the rule of 72 to teach how the value of money over time relates to inflation. For example, if inflation is at 6%, the purchasing power of a current dollar will only be half as much in about twelve years (72/6).
Limitations to the Rule of 72
The rule of 72 is a handy tool for estimating how long it will take for a financial balance to double in value, however, there are a few limitations to using this rule.
Limitations include the following:
- The rule only applies to investments that offer a fixed rate of return. If the investment offers a variable rate of return, the actual period required for doubling could be materially different.
- The rule only applies only works for periods of time long enough for an amount to double. For example, if a certificate of deposit is earning 4% per year, the rule of 72 estimates a period of 18 years would be required to double (+100% return) the principal invested. However, holding the investment for half that time (9 years) wouldn't be a good approximation for a +50% return.
- The rule of 72 loses its accuracy for very low and very high rates of return. For example, the accuracy of the estimate is almost perfect for an annual rate of return of 8%, but a ~5% margin of error applies for a rate of return as low as 1% or as high as 16%. Return rates that are below 1%, or exceed 16% would experience progressively higher margins of error.
Compound Interest Rule of 72 Example
The rule of 72 is a handy way to estimate how long it will take for an investment to double in value, and it only works with compounded rates. Compounding means that annual earnings on the investment (such as interest payments) are reinvested.
Consider the example of a Certificate of Deposit that pays 5% annual returns, with interest reinvested (compounded). Using the rule of 72, dividing 72 by 5 results in 14.4. This means it should take nearly 14 and a half years for the investment to double in value. Of course, this is just an estimate and not exact.
Bottom Line
The rule of 72 calculation is a quick way to estimate how long it will take for an investment to double in value. This equation can serve as a guidepost for investors considering financial decisions on the spot. The rule of 72 is a helpful tool, but it is important to remember that it is only an estimate. The estimate loses accuracy with very low or very high investment rates.
