Rule of 72: How it works

I have had a few friends ask me about how the rule of 72 works in the investing world. It is a quite simple tool used commonly with investing. It tells you how (approximately) many years it will take for your to double your money at a given rate. It is great for demonstrating why the stock market is the best investment for retirement funds.

Here is an example: Let's say you have $10,000 in cash ready to invest in something for the long term. I will apply the rule of 72 to determine how long it will take to make the $10,000 initial investment $20,000.

Savings account: Average rate for online accounts: 1.50%

72 / 1.5 = 48 years

Bonds: Average return on the bond market as a whole: 7.1%

72 / 7.1 = 10.14 years

Stocks: Average return on US Market: 10.5%

72 / 10.5 = 6.86 years

As illustrated in the above numbers it becomes obvious why people invest heavily into stocks. It only takes 7 years to double your money in stocks while a savings account takes 48 years. This shows how your money is working for you. Retirement assets are invested aggressively for this very reason.

This is a useful tool to use when deciding your asset allocation as well. You can split up your investments between cash savings, bonds, and stocks to come up with a weighted average return on your entire portfolio. Here is an example:

10% Cash Savings (at 1.5%) = 0.15
30% Bonds (at 7.1%) = 2.13
60% Stocks (at 10.5%) = 6.3

Average Return = 8.58% (total of numbers above)

You can set this up in Microsoft Excel or any other spreadsheet program and play with the portfolio breakdown to come up with the right mix for you. Use the rule of 72 on your average return to see how long it will take you to double your investment.