What Is The Rule Of 72?

By Jon L. Ten Haagen, CFP ®
asktheexpert@longislandergroup.com

Mary, Mary quite contrary how does your portfolio grow? With fixed income and growth equities and compound interest in your retirement plan at work.

We graduate from our learning institution and get a job. The job pays us a salary every two weeks or every month. We start work at about 25 years old and work until we retire which is around age 70. This gives us 45 years to accumulate the monies we will need to support us and our families in retirement. With people living longer lives this money may need to support us for 20 to even 30 or more years. We are growing this money, most likely in our retirement plan at work (401k, 403b, 457) which helps our money grow free of taxation until we take distributions after age 59 and a half.

Where do you get a decent rate of return on your investments? Look at these investment choices and create a good amount of diversification (various types of investments – growth, income, alternatives etc.) then look at the management of these various positions and what are their historical returns.

Over the years I have asked many people who come to my offices what are they are invested in with their 401k plan? Too many times they say they don’t know the specific sub-account choices. Then I ask how they made the choices they have? They said they talked with a fellow employee and they said go into the ‘stable’ value fund because it gives a fairly consistent return of about 2.5 percent and it is ‘stable.’ At 2.5 percent your investment will double in value in 28.8 years! How many doubles do you have before you retire?!    

Let’s take a look at the RULE of 72, a mathematical formula for calculating compound interest (much different than simple interest such as with a CD). Compound interest is the amount you earn on an interest-bearing account from year to year. The Rule of 72 helps you figure out how long it will take you to double your money (The Rule of 115 determines how long for your money to triple). Why does this matter? You are putting your money into a savings account, you will want to know how much money you will have in the account in five, 10 or 15 years. Helps you anticipate your future assets so you can determine if you are saving enough to accomplish your goals.

How does it work? You divide 72 by either the number of years you have or the interest rate you can get. This will give you the reciprocal. Divide 10 (years you want your money to double in) into 72 and you get 7.2 which is the interest rate you need for your money to double in 10 years.

Take a hard look at your investment choices. Too low a return and you will not get where you want to get. Too high a return and it could be too risky for your comfort level. Historically the stock market (DOW JONES Index) has returned over 10 percent over a very long time (over 100 years). Now it does not give you a 10-percent return every year but over the long term this is what has happened. I would suggest you talk with your Certified Financial Planner to determine what lets you sleep at night.    

Albert Einstein was a pretty bright fellow according to many. This quote is attributed to him. “Compound interest is the eighth wonder of the world and mankind’s greatest invention, because it is the mightiest force ever unleased for the amassing of wealth.”

The very best to you and feel comfortable giving us a call if we can be of assistance with your financial goals and needs.