The rule of 72 is an easy way to make fast financial calculations in your head (or on a sheet of paper)… no calculator is necessary. The idea is that you can determine how fast money will double based on an interest rate or rate of return. Divide 72 by the interest rate and that is the number of years it will take for the investment to double.
For example if a CD (Certificate of Deposit) is paying 6% it will double in 12 years because 72/6 = 12.
The rule of 72 can be used for decreases in value, such as inflation. If inflation is 4%, money under a mattress loses 4% per year in value. Because 72/4 = 18, that money’s value will be cut in half in 18 years. So positive returns divided into 72 tell how long it will take your investment to double and negative returns how long to lose half its value.
The rule of 72 provides convenient illustration of how fees can effect an investment. Let’s say you are considering two investments in your IRA managed by your brother-in-law Sam. Option A is to buy and hold SPY, an index fund that has an expense ratio of virtually 0% (0.09% actually) or option B tracking the same index but managed by the Sam’s company with a 2% expense ratio. Sam says “Hey buy my index and I get a commission and a chance to win a boat.” Using the rule of 72 you see that 72/2 is 36, meaning Sam’s index will only be worth half of SPY in 36 years. If you are 29 years old and want to retire at 65 (in 36 years) that’s half of your retirement money! Tell Sam to find some other sucker to win his stupid boat.
Finally you can use the rule of 72 together with inflation and expected return to plan your financial future. If you expect a 7% (nominal) return on your retirement portfolio and 3% inflation, that’s a 4% annual return, so your money will double — in inflation-adjusted terms — in 18 years. Now if inflation is 4% your real return is 3% and your real investment value will double in 24 years; that’s a whole 6 years longer. Possibly 6 more years until you retire. Add a 1% management fee and your real return drops to 2% and doubling time is now a whopping 36 years. Yes, even a 1% fee can cost you 12 more years until you retire!
The example above shows the destructive power of inflation and why even a 1% annual inflation underestimation can be a big deal. For tax payers that means tax brackets (based on the government’s CPI-U) gradually form an increasingly tight straight-jacket around your take-home pay. For Social Security recipients this means cost of living adjustments that simply don’t keep up with real world expenses.
The rule of 72 is a powerful tool for financial estimation. The rule of 72 is not perfectly accurate, but it is generally pretty close to the target. It is, however, easy to use and can be used to explain financial concepts to people that aren’t that “mathy”. It is a great way to start explaining finance to kids; while being a tool powerful enough that is also used by Wall Street pros.
It doesn’t take a rocket scientist to warn about the US’s debt woes. For example this finance blog warned about it April of 2010. And Bill Gross and PIMCO quit holding US Government bonds recently. Now S&P joins the bandwagon with a warning that US Treasury debt’s AAA rating is at risk. This in effect would mean lowering the government’s credit score.
Predicting particularly congressional outcomes is not my strong suit. But I have been predicting growing US debt online since 1998. Then the debt was a mere $5.3 trillion. And I’ve been right that not only nominal debt, but debt as a percentage of GDP would rise.
To so many investors like myself the unsustainability of our current fiscal course is blatantly obvious. During the day I work for a successful tech company, and I get a significant portion of my pay that varies based on the companies performance. If profits increase my coworkers and I get more cash; if the profits dwindle so does my pay. If the company stock rises, so does my compensation. And if it falls, my compensation falls with it. It is a smart system, commonly called profit sharing.
Might I suggest a similar compensation plan for federal government workers. I’d call it deficit sharing. (I’d prefer to call it surplus sharing, but get real.) Beyond a certain point (say the average US annual wage) base pay is fixed and all future raises are in terms of variable pay increases. And variable pay is awarded at the end of each fiscal year. The proportion of the federal deficit to federal spending prorates this variable pay. If someday there is a balanced budget there is a 1.0X multiplier to variable pay. If there is a deficit then variable pay is reduced. Should there be a surplus a multiplier of greater than 1 would apply. Share and share alike. The private sector employees do… and right now we are sharing the sacrifices. So should Federal employees.
What to do you think America?
Why not evaluate US government bonds like corporate bonds? Take a look at the balance sheet, cash flow, and anticipated future cash flow. Look at current management… where are the they taking the organization?
So the trend is not so good. Ever increasing debt implies more debt supply. Can the demand keep up. Not at current yields, no. Yields up, prices down.
Management? Fiscal discipline? Not anytime soon. Cash flow? The situation is not positive.
So I’m not very inspired to buy US Debt today. Maybe, maybe TIPS. But traditional US Bonds? Not with a credit report like this.
I’ve been reading through the prospectus for some of the Vanguard tax-exempt funds. There are four that generally cover the municipal funds markets:
They all have great expense ratios of 0.2% and credit ratings (for what they’re worth) of AA or AA-. What is most interesting to me is a comparison of duration to yield. Duration, in brief, is a standardized measure of bond price sensitivity to changes in interest rates. High duration bonds (or funds) swing more to a 1% change in interest rates than lower duration bonds. When I graph the relationship I get a very straight looking line:
In essence this is the current yield curve for this family of funds. The leftmost point is the short-term tax-exempt bond fund, followed by limited-term, then intermediate term, and finally long-term.
So what was my decision? I bought into 3 of the 4, the short-term, medium-term, and long-term. They all look like great funds. I’ll keep you posted.
I spent a semester studying bonds, and I was just scratching the surface of the subject. However, rather than regurgitating a bunch of facts and boring data, lets keep it simple and start with Bond Funds. I recommend a few:
1) PIMCO Total Return
2) Vanguard Total Bond Funds VBMFX, VIPSX, and others: Vanguard Bond Link
The question used to be “why buy bonds?” Lately the question is “why didn’t I own *more* bonds?”
Either way, I seldom recommend sudden large changes to portfolios. Assuming you’ve been beaten up by stocks (I have) and have lost some of the risk tolerance you thought you had, maybe its time to consider looking at bonds. Rather than moving funds around, why not just change your allocation of new funds. If you have a 401(k) consider changing your new investment elections.
Bonds and bond funds can help you sleep better at night. Especially Treasury Bonds and TIPs.
Another bond-like investment is a CD (certificate of deposit). The FDIC insurance (now up to $250K) helps peaceful slumber. The wrinkle is getting them into your retirement account.
Bottom line: Any portfolio should contain bonds (or bond-like) investments to be considered balanced.
P.S.: Today’s Fun money update: $21,066. Decreases in my SPY call are approximately offsetting decreases in my SPY underlying. (Yes, that sentence is correct.)