Many books on investing explain the rule of 72, which makes it easy to estimate how long it takes for an investment to double at a given rate of growth. In most of these books it’s presented as a bit of trivia or at best a handy math trick. In That Thing Rich People Do I show how it can be used to gain insight into key aspects of investing, including the benefits of getting started early and the importance of minimizing expenses.
In case you haven’t run into it before, here’s how it works. If you know the rate of growth for an investment, divide that number into 72. The result will tell you how many years it will take for the investment to double (with compounding) at that rate. For example, an investment growing at 6% will double in 12 years, because 6 times 12 is 72.
It’s a happy coincidence that the magic number is 72 because that number is so easy to divide. It’s an even multiple of 2, 3, 4, 6, 8, 9 and 12.
Starting early
The rule of 72 can be used to illuminate the importance of getting started early with saving and investing. Consider an investment that grows at a rate of 8% per year. The rule of 72 tells us it will double in about 9 years. If I invest $1,000 at age 56, the money will double to $2,000 by the time I retire at age 65. Money I invest at age 47 will double twice, providing me with $4,000 at retirement. At age 38 I can expect my money to double three times, and investments begun at age 29 will double four times, producing $16,000. Any 20-year-olds out there? Setting aside $1,000 now can provide you with a whopping $32,000 at retirement.
Minimizing expenses
Your money doesn’t grow based on the gross increase in value of your investments. You have to subtract investment expenses to get the true rate of growth. Minimizing investment expenses is easy enough in a world where low-cost index funds are readily available and many of us can use Roth IRAs to eliminate tax on our investment income. Yet many investors incur much higher expenses — without producing any higher gross returns — through high-cost mutual funds, excessive trading, or the use of complicated products such as variable annuities. The difference in annual expenses between an efficient and inefficient investor can be two percentage points or more per year.
Our book on investment principles
The rule of 72 can illuminate the importance of this issue. A period of 36 years might be considered a rough approximation for a typical lifetime of investing. We certainly hope people will start early enough and live long enough to have money invested much longer than that, but many of us don’t settle into serious saving until we’re well into our careers, so let’s think of 36 years as a reasonable time frame. Here’s the key point: over a period of time that long, incurring an extra two percentage points per year of investment expenses will leave you with half as much wealth.
For example, if your money grows at 6% after taking expenses into account, the rule of 72 says it will double every 12 years, so it can double three times over a period of 36 years. Eliminate two percentage points of expenses, though, and we can expect growth at 8%. Dividing 8 into 72 we see that the doubling period has been cut to 9 years, allowing your money to double four times in the same period of time. One more doubling means you end up with twice as much wealth, without added saving or any other effort beyond adopting a low-cost approach to investing.
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