Introduction
The Rule of 72 is a great way to help plan for the future. It is a quick and easy method for calculating the impact that growth and inflation can have on your money and other investments.
Compound Growth/Interest
The rule can be applied to investments where the investor is enjoying compound growth. Compound growth, in its simplest terms applies in cases were “money makes money”.
For example, with a savings account you receive an annual interest rate (return) and for the sake of this article we will consider the scenario where you invest £1000 into a savings account and leave it for a number of years with it enjoying an interest rate of say 5% net (those were the days!)
After year 1 your money will have grown to £105.00 (£100 plus 5%) – at the end of year 2 your money will have grown to £110.25 (£105 at the start of year 2 plus another 5% interest. This is COMPOUND INTEREST – your money has earned money – the £5.00 interest received at the end of year 1 has itself earned 5% interest; in this case the £5 has earned 25 pence interest.
The Rule of 72 – how to use it
To work out roughly how long it will take for a given investment to double in value, simply divide the interest rate being received into 72 – this will give you the length of time required for money to double in value.
For example, of you are receiving 6% net interest per annum your money will double in value in 12 years (72/6 = 12 years).
Likewise, the same principle can also be used to calculate the effect of inflation (increase in the cost of living) to halve the value of your money – e.g. if inflation is running at 3% per annum then your money will halve in real value (it’s purchasing power) in 24 years.
Why is this Principle important?
When planning your finances for the future you need to make a number of assumptions about how finances will change over time. Retiring today on £20,000 per annum pension may be comfortable for many people – but if you retire on £20,000 per annum in say 50 years time then the purchasing power of this income will be considerably less if the cost of living rises steadily over the next 50 years.
If you were to make an assumption that say inflation was to run at an average of 4% per annum then the real cost of living doubles every 18 years.
This is important for anyone planning to build a portfolio of assets over the longer term. In this example, consider someone age 29 – if we assume inflation of 4% per annum the cost of living will have quadrupled between now and retirement at age 65.
If the 29 year-old considers they can comfortable live on £25,000 if they retired today with all mortgages and other debts repaid by the time they retire, then by the time they reach 65, assuming 4% inflation, their portfolio will need to provide them with £100,000 per annum to maintain the same standard of living.