The rate at which your capital accrues is a vital factor to keep track of. This will enable you to figure out when to make investments, what assets to select for your immediate and long-term objectives, and how much to put in each asset or plan.
Experts use different rules and strategies to easily estimate the growth of investments in any portfolio. One such guideline is the rule of 72 in finance. If you are a beginner who is just getting started on your investment journey, understanding how the rule of 72 works can help you make quick mental calculations about how quickly your investments will grow.
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What is the Rule of 72 in Finance?
The rule of 72 helps you compute the time required to double your investments. Undoubtedly, technology has advanced to a point where you can determine this sort of information by utilising Microsoft Excel or a comparable program. However, the rule of 72 is beneficial in the event that you are not able to take advantage of such a program, or if you wish to rapidly calculate the amount of years in which your investment could double.
What is intriguing is that this principle was not initially conceived in the monetary domain. Its roots lie in a mathematical theorem that dates all the way back to the late 1400s; it was then that Luca Pacioli wrote about it in Summa de Arithmetica. Even so, some historians suggest that this law may be far older.
The Formula Used in the Rule of 72
The formula used in the rule of 72 in finance is simple. All you need to do is divide the number 72 by the annual rate of return from your investments. Mathematically, the formula for the rule of 72 is as follows:
| Number of Years to Double an Investment = 72 ÷ Expected Annual Rate of Return |
For example, say you invest Rs. 1 lakh in a scheme that offers an annual return of 7%. In this case, your investment will double i.e. grow to Rs. 2 lakhs in 10.28 years (i.e. 72 ÷ 7).
Conversely, you can also use the formula to compute the minimum rate of returns required if you want to double your investments within a specific period. In this case, the formula will be rearranged as shown below.
| Expected Annual Rate of Return = 72 ÷ Number of Years to Double an Investment |
So, if you want to double your investment in 6 years, you need to invest in an asset or scheme with an annual rate of return of at least 12% per annum (i.e. 72 ÷ 6).
A Few Key Things to Know About the Rule of 72
Before you use the rule of 72 for planning your investment strategy, there are a few important things that you should know about this method. Check them out below.
- Compound Interest vs. Simple Interest
This rule is only applicable to assets that offer compound interest. If an investment option offers simple interest, the rule of 72 will not work for that scheme or asset. The difference lies in the fact that simple interest occurs only on the principal amount, but compound interest accrues on the principal amount as well as the interest earned up to that point.
- A Limited Range of Return Rates
The rule of 72 only works well within a limited range — typically between 6% and 10%. For more accuracy, if the return rates diverge from the threshold of 8%, here’s what you need to do:
- Add 1 to 72 for every 3-point increase from 8%
- Subtract 1 from 72 for every 3-point decrease from 8%
For example, say the returns from an asset are 5%. Since it is less than the 8% threshold by 3 points, you must subtract 1 from 72 and use the rule of 71 instead. Similarly, if the returns from an asset are 11% (i.e. more than the 8% threshold by 3 points), you must add 1 to 72 and use the rule of 73 instead.
- The Level of Accuracy
The rule of 72 is mostly an approximation rather than an accurate representation of the time value of money. The formula as per the time value of money method is as follows:
| Time Taken to Double an Investment = Log (2) ÷ [Log (1 + r/100)] |
Where ‘r’ is the expected annual rate of return from the investment.
Using the above formula, an investment of Rs. 1,000 that offers 6% returns per annum will double in 11.8957 years. When you compute the same metric using the rule of 72, you get 12 years as the answer, which is approximately the same.
Conclusion
The rule of 72 in finance may be more accurate in some scenarios than others. So, while you can use it as a benchmark for investment planning, it should not be the only rule guiding your strategy. You can make use of an online calculator to plan your investments better and determine an asset allocation that will help you achieve your financial goals within the timelines required.
