How to Use the Rule of 72
A fun rule, but not as useful as legitimate planning
The Rule of 72 is a math rule that lets you easily come up with an approximate estimate of how long it will take to double your nest egg for any given rate of return. The Rule of 72 makes a good teaching tool to illustrate the impact of different rates of return, but it makes a poor tool to use in projecting the future value of your savings, particularly as you near retirement. Let's look at how this rule works, and the best way to use it.
How the Rule of 72 Works
Take 72 divided by the investment return (or interest rate your money will earn) and the answer tells you the number of years it will take to double your money.
- If your money is in a savings account earning three percent a year, it will take 24 years to double your money (72 / 3 = 24).
- If your money is in a stock mutual fund that you expect will average 8% a year, it will take you nine years to double your money (72 / 8 = 9).
You can use this Rule of 72 Calculator if you don't want to do the math yourself.
Use as a Teaching Tool
The Rule of 72 can be useful as a teaching tool to illustrate the different needs and risks associated with short-term investing versus long-term investing.
For example, if you are taking a trip a mile up the road to the corner store, it doesn’t much matter if you’re driving at 10 miles an hour, or 20 miles an hour. You’re not traveling that far, so the extra speed won’t make much of a difference in how quickly you get there. If you’re traveling across the country, however, extra speed will significantly reduce the amount of time you spend driving.
When it comes to investing, if your money is used to reach a short-term financial destination, it doesn’t much matter if you earn a 3 percent rate of return or an 8 percent rate of return. Since your destination is not that far off, the extra return won’t make much of a difference in how quickly you accumulate money.
It helps to look at this in real dollars. Using the Rule of 72, you saw that an investment earning 3% doubles your money in 24 years; one earning 8% in 9 years. A big difference, but how big is the difference after just one year?
Suppose you have $10,000. After one year, in a savings account at a 3% interest rate, you have $10,300. In the mutual fund earning 8%, you have $10,800. Not a big difference.
Stretch that out to year 9. In the savings account, you have about $13,050. In the stock index, mutual fund according to the Rule of 72 your money has doubled to $20,000. A much bigger difference. Give it another 9 years and you have about $17,000 in savings, but about $40,000 in your stock index fund.
Over shorter time frames, earning a higher rate of return does not have much of an impact. Over longer time frames, it does.
Is the Rule Useful as You near Retirement?
The Rule of 72 can be misleading as you near retirement. Suppose you are 55, with $500,000 and expect your savings to earn about 7% and double over the next 10 years. You plan on having $1,000,000 at age 65. Will you? Maybe, maybe not. Over the next 10 years, the markets could deliver a higher or a lower return than what averages lead you to expect.
By counting on something that may or may not happen, you may save less, or neglect other important planning steps like annual tax planning.
The Rule of 72 is a fun math rule, and a good teaching tool, but that's it. Don't rely on it to calculate your future savings. Instead, make a list of all the things you can control, and the things you can't. Can you control the rate of return you will earn? No. But you can control the investment risk you take, how much you save, and how often you review your plan.
Even Less Useful Once in Retirement
Once retired, your main concern is taking income from your investments, and figuring out how long your money will last depending on how much you take. The Rule of 72 doesn't help with this task. Instead, you need to look at strategies like time segmentation, which involves matching up your investment with the point in time where you will need to use them. You'll also want to study withdrawal rate rules which help you figure out how much you can safely take out each year during retirement. The best thing you can do is make your own retirement income plan timeline to help you visually see how the pieces are going to fit together.
If financial planning were that easy, you might not need a professional to help. In reality, there are far too many variables to consider. Using a simple math equation is no way to manage money.