As an investor, you should have some rules of thumb to help you do quick calculations when necessary. Here is a mathematical trick that will help you calculate how quickly you can grow your money with a particular investment — it’s called “The Rule of 72″…
The Rule of 72 will allow you to determine how long it will take for an investment to double given a specific rate of return. The rule works as follows:
Divide 72 by the rate of return, and the result will be an estimate of the number of years it takes to double your investment.
As an example, let’s say that you are receiving an 8% return by investing in a diversified stock portfolio:
72 / 8 = 9
So, an amount of money invested at 8% will double about every 9 years. Someone who invests $10,000 in 2015 with an 8% return will have $20,000 in 2024, $40,000 in 2033, and $80,000 in 2042.
Let’s try the same thing with a 15% return:
72 / 15 = 4.8 (let’s round that to 5)
So, if the same investor above were to invest $10,000 in 2015 with a 15% return, he would expect to have $20,000 in 2020, $40,000 in 2025, and $80,000 in 2030. That’s a full 12 years sooner than if he were only able to get 8%! (A couple percent can make a big difference)
The Rule of 72 can also be used to determine what rate of return you need to receive to turn a starting investment into an ending investment.
For example, let’s say you are 45 years old, and have a goal to retire by 55. You have $500,000 in savings, and know that you need $3,000,000 to retire. So, you need to increase your $500K to $3M in 10 years…what rate of return would you need to accomplish that?
To find out, first figure out how many times your money needs to double to reach your goal. In this case, $500K would need to double two-and-a-half times ($500K to $1M, $1M to $2M, and then a half double from $2M to $3M).
Now you know that your investment needs to double 2.5 times in 10 years. This is the same as doubling every 4 years (10 / 2.5).
We know from The Rule of 72 that if we divide 72 by the rate of return, we get the number of years to double an investment. It also works the other way — by dividing 72 by the number of years to double, we can get the rate of return.
In this case, we divide 72 by 4, and we get 18. This is the rate of return (18%) that we need to get to double our money every 4 years, and therefore the rate of return needed to turn $500,000 into $3M in 10 years.
If our investor can find an investment that returns 18% annually, he will meet his retirement goal.