In the FinancialVerse, there are certain rules of thumb or quick financial calculations that you need to know. In my mind. one of the most important is the Rule of 72. The formula is simple: 72 divided by the annual interest rate earned on the investment = years it takes to double.
Try plugging in various interest rates (or rates of return) from the different accounts your money is in, from online savings accounts and money market accounts to index and mutual funds. Here are a few examples, if your account annually earns:
1%, it will take 72 years for your money to double (72 / 1 = 72)
3%, it will take 24 years for your money to double (72 / 3 = 24)
6%, it will take 12 years for your money to double (72 / 6 = 12)
9%, it will take 8 years for your money to double (72 / 9 = 8)
12%, it will take 6 years for your money to double (72 / 12 = 6)
This formula gives you a quick calculation on how fast your money will accumulate for whatever need you are saving and investing. If you are careful and put your money in the right places, it can grow substantially over time, thanks to the power of time and compound interest.
Here are some observations about this foundational rule of saving and investment:
The rule clearly demonstrates why it is important to start saving early. In this low interest rate world that we live in, it will take much longer to double your money. With more time, a lower interest rate may give you enough to reach your goals. With less time, you may need a higher interest rate.
The higher the rate of return the faster your money doubles.
You will need to balance the rate of return offered on the investment with your tolerance for risk and the likelihood of getting the high advertised returns. For example, a lottery ticket offers a very large payoff but with terrible odds. The likelihood of receiving consistent positive returns on your money is quite low.
Low rates of return will require that you save more to get to your target accumulated amount. For example, if your money sits in a standard bank savings account and earns just 0.25% annually, it would take 288 years to double. That is why it is important to investigate putting some of your money into a higher yielding internet savings account or certificates of deposit.
If you in the stock market, whether through an employer-sponsored 401(k) plan, a traditional or Roth IRA, an individual brokerage account or somewhere else, you’ll likely earn larger returns. But these returns come with higher risk and volatility as we have seen during 2020. You always need to balance risk and return tradeoffs as you invest your precious money.
Summary
The “Rule of 72” is one of the key rules of thumb in the FinancialVerse that should help you ask the right questions before making savings and investment decisions. You should always know what you money is earning and the risks you are taking.
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