To attain your objectives, you need to know how much money to invest, how long it will take, and what average rate of return you can realistically achieve. The better you answer these questions, the simpler goal setting becomes.
But figuring out these statistics may be difficult. If you have trouble creating goals because the process appears too tough, this common guideline may help.
Rule of 72 defined
Using an average yearly return, the rule of 72 tells you how long it will take for your money to double in value. Take 72 and divide it by the predicted rate using the rule.
For example, if you invested $10,000 and expect it to grow at a 10% annual rate, it would take 72/10 = 7.2 years to double your money. The longer it takes to double your money, the more conservatively you invest, and the more aggressively you invest, the faster you should double your money. This formula states that if you earn an average of 12 percent, your money will double in six years (72/12). Your investment should double in around 72/8 = nine years if you earn an average of 8 percent.
The Rule of 72 is based on several asset types
Using historical rates of return, you can obtain an understanding of how various asset allocation schemes have fared over time. In the 90 years from 1929 to 2019, here is how the 72-year rule looked for various stock and bond portfolios.
Pros of the rule of 72
Most importantly, using this rule is quite straightforward. You just need a piece of paper, a pen or pencil, and some basic arithmetic abilities to make the calculations.
After you’ve done your calculations, you’ll be able to establish some basic objectives. For the sake of argument, assume your objective is to save $50,000 for your child’s college education over the course of 18 years. You currently have $12,500 to invest. In nine years, you’d like it to have doubled to $25,000, and in 18 years, you’d like it to be $50,000. You might calculate the average return by using the rule of 72. You may invest your money in accordance with the 8 percent guideline once you’ve calculated it.
Limitations of the rule of 72
Over a period of 90 years, the average return on stocks would be little over 10% if you put all of your money in them. These kind of averages are easier to capture the longer you let your money to develop. For shorter periods of time, however, you may see that your averages change more and are less consistent.
The typical returns you get from the stock market depend on how long you invested and might fluctuate. A five-year investment in the SPDR S&P 500 ETF (NYSEMKT:SPY) would have yielded an average return of 15.12% during the past 15 years. A 10 year investment yields a return of 13.49%, while a 15 year investment yields a 9.53% return.
However, if you had begun investing in the identical ETF in 2000, the outcome would have been much different. Because of this, your five-year average is -0.71 percent after experiencing both the dotcom boom and the financial crisis. As a result, your 10-year average return would have been 1.2 percent, and your 15-year average return would have been 6.09 percent.
If you follow this guideline, it may be tempting to invest just for the sake of getting a bigger return in order to have a shorter doubling time. However, a greater rate of return means the investment will be more volatile. Instead of investing in accordance with your risk tolerances, you may discover that you cannot stay the course during down markets since your portfolio is not invested in that manner. Because your investments are excessively aggressive, the figures you compute will be incorrect.
Using the rule of 72 will allow you to quickly and easily calculate objectives and begin your financial planning process. However, because of its limits, you’ll want to go through the results with a planner before moving on. If you evaluate your accounts on a regular basis, such as yearly, you’ll be able to account for market fluctuations both up and down and make changes as necessary.
The author’s views are represented here, and they may differ from those of a Motley Fool premium advice service. We’re a jumbled bunch! Challenge an investment theory, even if it’s our own, helps us all think critically about investing and make choices that help us grow wiser.
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