Here are guidelines relating to using the Rule of 72 & doubling your money:
The Rule of 72 is indeed a fascinating math rule! By using it, you get to know how much time it will take to double your money. All you require is to assume a rate of return. It is a convenient way to ascertain the power of compounding; especially those who escape from complex logarithmic calculations.
In the Rule of 72, you have to divide 72 by the rate of return. That’s all you need to do to arrive at an approximate number of years that are required to double the invested amount.
In this, there’s no withdrawal or leakage of any accretions earned during the investment tenure. It assumes that you are going to reinvest the dividend and capital gains earned on the investment.
Hence, prior period interest forms part of the principal to calculate the succeeding period interest.
It is an excellent tool to understand the behaviour of money over different time horizons. It acts as a thumb rule to arrive at financial estimates. You can ascertain the intrinsic worth of an investment using mental maths.
The rule of 72 can be applied using the following formula:
Number of years to double = 72/ Required Rate of Return
How to use the Rule of 72?
Rule of 72 can help you gauge which is the most attractive investment opportunity. In fact, you can draw a comparison. You may arrange the available havens in a hierarchy.
Suppose you want to invest in a bank term deposit (FD) that offers 8% rate of return. You have to just divide 72 by 8. You get to know that your money will double in 9 years. Similarly, if you decide to invest Rs 1Lakh in bonds having a coupon rate of 10%; then you will earn Rs 2Lakh after 7.2 years.
It means the higher the rate of return, the lesser time your money will take to double. In other words, a higher rate of return will make your money grow faster. Hence, you can assess that bonds are a better investment haven than bank FDs.
If you take the case of equity, the average return is around 12%.
Does that mean your money will double in 6 years?
Maybe! May not be!
It is because returns are not guaranteed in case of equities. It fluctuates according to the stock market ups and downs. Additionally, other intrinsic and extrinsic factors affect the share prices. Such factors are beyond your control.
The concept is pretty simple. Based on the Rule of 72, you can predict the exact time to double your money only in case of fixed-interest bearing instruments. But in all other kinds of investments, the market risk renders the Rule of 72 futile.
Inflation and Rule of 72
You must be well aware that inflation reduces your purchasing power. It squeezes the basket of goods that can be bought with the same sum of money.
Rule of 72 helps you determine the impact inflation is going to have to your purchasing power. It tells you how many years will it take to halve the value of your money. You can judge the value of money at a point in time in future.
Suppose the current rate of inflation is 6%. It implies that value of your money will be halved upon completion of 12 years. So, if you are buying 1 kg of apples for Rs 100 today, after 12 years the same quantity will cost you Rs 200.
In other words, you will be able to buy a ½ kg of apples for Rs 100 after 12 years.
The higher the rate of inflation, the faster your money’s worth will deplete.
In this way, the rule of 72 can be handy to decide on a variety of issues. You can use it to determine the amount of sum assured on a term insurance.
Also read: Risk vs volatility: here’s the difference
Risk factors and Rule of 72
Rule of 72 is exclusively based on the rate of return on investment. The formula gives emphasis only to one aspect of the investment i.e. returns.
But what about the inherent risk in an investment? Does it account for that?
The answer is a Big No.
Nowhere, the rule of 72 talks of risk in an investment. When it comes to investing, risk-adjusted returns becomes more important than overall returns. Risk-adjusted returns give a holistic view of the appropriateness of an opportunity for an investor.
Consider two mutual fund schemes A and B. Both are offering 24% rate of return. Rule of 72 would indicate that both the schemes 3 years to double the money. Additionally, remember that there are no guaranteed returns.
Now, how do you differentiate between the two?
Suppose Standard Deviation (SD) of A is 15% while SD of B is 13%. It means that while assuming relatively lesser risk, B gives equivalent returns as A. Thus, B gives better risk-adjusted return than A.
But yet another question is which scheme is better for your risk appetite?
A scheme having SD of 13% is moderately risky. If you are a risk-averse investor who prefers SD lower than 13%, then even scheme B is not meant for you. In such a scenario, you need to explore other alternative schemes for yourself.
Hence, you cannot follow the Rule of 72 blindly. You need to consider a lot many scientific factors to arrive at a final decision.
Escape Ponzi Schemes with Rule of 72
Rule of 72 isn’t all that bad. It can help you from getting fooled by the Ponzi Schemes.
Ponzi schemes are fraud money collection schemes which promise a sky-high rate of return. These collect money from new investors and distribute huge dividends among a few old investors. It lures new investors to join the scheme. The saga continues till the money flows in. The moment they stop getting new investors, the fraudsters escapes with the corpus.
Suppose a scheme promises to double your money in a year. In that scenario, you can calculate the rate of return. Going by the rule of 72, the scheme has to generate returns at the rate of 72% for that to happen.
Now that’s pretty unbelievable return to achieve in such a short period. Hence, consider that scheme to be a sham.
Rule of 72 can be used as a thumb rule in investment analysis. But to gather a deeper insight, you need to use other concrete measures.