The Rule of 72
How to Predict Investment Returns and Make Smart Financial Decisions
A popular comedy movie in Bollywood shows one of its lead characters offering a scheme which can double money in just 25 days.
For money to double in 25 days, the annual interest rate would have to be 1,460%.
How does one figure out the time needed to double the returns?
The returns in various asset classes – equities, real estate and precious metals – is largely non-linear, but fixed-income or debt instruments tend to have linear growth in returns.
When you invest in a fixed deposit, for instance, the tenure of your investment is fixed, as is the rate of interest which you will earn.
When selling such products, bankers often give you a time frame in which your money will double - they are not trying to fool you. Instead, they use a formula which indicates the amount of time it would approximately take for your investments to double.
The Rule of 72
Let's clarify further - the Rule of 72 is a useful method for estimating the duration needed for your investment to double its value at a specific interest rate.
Divide 72 by the interest rate of your investment to find out the number of years it takes to double.
For instance, investing 10,000 rupees at a 6% rate would take 72/6 = 12 years for the investment to reach 20,000 rupees.
With an 8% rate, the doubling period would be shorter, around nine years.
On the other hand, at a 4% rate, it would take a longer 18 years!
Remember that the Rule of 72 is based on compounding interest rates, not simple interest.
This guideline is most precise for interest rates between 6-10%.
Though the Rule of 72 is a straightforward financial principle, it can act as a foundation for evaluating the worth of your fixed-income investments.
The rule can also be used the other way around - you may want to double your investment in, say, eight years. What should be the returns that the investment makes each year?
You must divide the number 72 by the years, which is 8 in this instance, and the answer 9 indicates that you need to invest the money in an instrument which earns at least 9% each year.
Exceptions To The Rule
Although the Rule of 72 is a valuable heuristic for estimating the time required to double an investment, its accuracy can be affected by several factors:
Interest rate range: The rule is most precise for interest rates between 6% and 10%. As rates deviate from this range, the approximation becomes less accurate, with the error increasing as the rate moves further away.
Compounding frequency: The rule assumes yearly compounding, so when an investment compounds more frequently (e.g., semi-annually, quarterly, or monthly), the rule is less accurate. In such cases, a more accurate formula should be employed.
Continuous compounding: For investments with continuous compounding, the Rule of 72 is inapplicable.
Variable interest rates: The rule doesn't apply when interest rates change over time, as it assumes a constant rate throughout the investment period.
Non-linear investments: The rule is most applicable to fixed-interest investments, like bonds. For investments with non-linear growth (e.g., stocks or real estate) that experience fluctuating returns, the rule may not be accurate or applicable.
While the Rule of 72 is a convenient tool for rough estimations, it has its limitations and might not yield accurate results in every situation.
Nevertheless, it is a convenient and useful tool to get off the starting block
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