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.