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What is the Rule of 72?

By David Becker

How to double your money by reinvesting your profits consistently

The Rule of 72 is a simple formula that tells you how long it will take you to double your money with a fixed rate of return. You can do it using a concept called compounding, which allows you to enhance returns if you reinvest profits consistently. Compounding is a very important concept to use when you are evaluating wealth building.

What is compounding?

Compounding can be defined as the investment process that occurs when earnings from interest or capital gains are reinvested along with the initial principal. The growth in your portfolio when using compounding will generate earnings from both the initial principal as well as the accumulated profits from preceding periods. Your portfolio will grow at an exponential rate.

Compounding occurs on both assets and liabilities. So if you owe money to a credit card company, the amount that you will owe them will continue to increase if you don’t pay off more than the additional debt you incur from interest charges.

Here is how compounding works. Let’s say you have $50,000 and you earn 7 per cent annually. After the first year, your account value will be $53,500, which is the initial principal along with the profits of $3,500 you earned from receiving 7 per cent interest ($50,000 * 7 per cent = $3,500).

During the second year, the 7 per cent gain will be calculated on $53,500 instead of the initial principal of $50,000. After 10 years the value of the account – assuming no withdrawals and steady 7 per cent interest – will be $98,357.57.

Compounding strengthens with frequency

Compounding strengthens as the frequency of interest payments increases. For example, if you receive a 7 per cent payment on your principal twice a year instead of once a year, you will generate higher value, because the earnings will be compounded at a greater rate.

Instead of receiving $3,500 once a year, if you got half of that money in the middle of the year and you receive an interest payment on the additional $1,750, the value of the account will grow at a faster rate.

Compounding is key to wealth accumulation. Strategies that generate dividends that pay quarterly allow investors to reinvest their dividends to purchase additional shares of stock, which create a greater dividend. By reinvesting in more shares of dividend-paying stocks, an investor is increasing the compounding ability of the portfolio by consistently increasing the future income growth of a dividend payout.

The Rule of 72 as a guideline

The Rule of 72 is a guideline that can be used to determine approximately how long it might take for an investment to double, based on a fixed rate of return. By creating a ratio where you divide the annual rate of return by 72, you can create a rough forecast of the number of years it will take to double your initial investment.

For example, if you invested $10 at a fixed rate of 10 per cent per year that was paid annually, it would take 7.2-years (10 per cent/72=7.2) to grow the portfolio to $20 dollars. Remember, this is a rough estimate. A simple formula that you can use to determine the number of years that it will take your investment to double if you reinvest your earnings with a fixed interest is:

Number of Years to Double = 72/Interest Rate.

The benefits of the Rule of 72, is that it can quickly allow you to calculate how long it will take your money to double based on a fixed interest investment. You can also use the rule of 72 for sales forecasts, inventory accumulation, or even inflation expectations.

Take away

  • The Rule of 72, is a guideline that can be used to determine how long it will take to double your money using a fixed investment.
  • The Rule of 72, is based on the concept of compounding.
  • Compounding occurs when you reinvest the earnings that you receive from a fixed investment, such as dividends or interest.
  • The Rule of 72 is based on reinvestment once a year.
  • The frequency of compounding will enhance your returns but alters the simple formula used in the Rule of 72.
  • A handy formula to determine the number of years it will take to double your investment using a fixed interest rate that is reinvested is: (number of years to double = 72/interest rate).

FURTHER READING: Money-saving ideas: Five easy, painless ways to plan for the future

FURTHER READING: How to protect your money in a recession and invest wisely

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