posted on November 20, 2013 11:00
As you consider saving for retirement, a simple rule of thumb can be very useful in determining what your investments will be worth in the future. It is called the “Rule of 72.” This simple rule quickly tells you how long it takes to double your money at a given rate of return (or interest rate). Here’s how it works: to determine the time required to double your money, divide 72 by the expected rate of return. The result is the approximate number of years it will take to double your investment.
As an example, suppose you expect your $300,000 in investments to average 8% per year. Dividing 72 by 8 equals 9; hence, it will take about nine years to double your money to $600,000 (excluding taxes and any additional contributions). Alternatively, if you only expect a 6% return, the rule implies it will take 12 years (72 divided by 6 equals 12) to double your money.
This simple rule of thumb has been remarkably accurate. The result using the Rule of 72 is within a few months for most rates of return one would expect from a diversified investment portfolio.
Using the Rule in Retirement Planning
The Rule of 72 is useful in retirement planning to help to determine how your retirement savings might grow in the coming years. For example, say you are 45 years old and plan to retire in 18 years at age 63. If you currently have $300,000 in retirement investments and expect an 8% investment return, you would expect your retirement nest-egg to grow to $1.2 million at retirement – doubling twice over 18 years. As we noted above, at an 8% return, an investment doubles in nine years. So by age 54, the account should have doubled to $600,000, and after another nine years (at age 63), it will have doubled again to $1.2 million. This quick analysis provides a good starting point for retirement projections. A financial advisor can help take the analysis further to determine how much to save each year and how to build a diversified portfolio to meet your target return.
Comparing Investment Options
The number of years it takes to double your investment is also an interesting way to compare different investment options. It has the advantage of taking into account the power of compounding returns as opposed to just the difference in annual return. Suppose you are considering either buying a 5-year Certificate of Deposit (CD) with a 2% annual interest rate or investing in a conservative, diversified portfolio that is expected to return 6% annually. Although the CD is a safer investment, it also takes nearly 3 times as long to double your money as an investment portfolio returning 6% annually. By taking more investment risk, you are rewarded with a higher expected – but not guaranteed – return on your investments.
To put this in context, if you are 30 years old and plan to retire at age 66, your CD investment would double over the next 36 years (assuming you buy a new CD every 5 years and interest rates stay at 2%). Alternatively, if you choose the diversified portfolio and it returns 6% over the next 36 years, at retirement you would have eight times your initial investment – having doubled every 12 years. The net result is a nest-egg four times larger at retirement just by selecting the higher return portfolio when you are young. Of course, this higher return is not guaranteed and it will certainly experience a greater level of volatility than a bank CD.
Therefore, whether you are comparing two potential investment approaches or trying to calculate your future net worth, the Rule of 72 provides a simple way to quickly estimate how long it will take your investments to double in value.