The Rule of 72
Investopedia defines the rule of 72 as a quick, useful formula that is popularly used to estimate the number of years required to double the invested money at a given annual rate of return. Of course, there are calculators and spreadsheet programs that can accurately calculate the precise time required to double invested money to the nth degree. But the rule of 72 is a handy tool that can be used to quickly approximate how quickly a given amount of money can be expected to double.
The way it works is very straight forward and easy to use. You simply divide 72 by the expected growth rate to determine the number of years to a double.
For example, if you expect the S&P 500 to grow at an average annual rate of 7%, the index will double in slightly more than 10 years. If you are more optimistic, the average will double more quickly and if your expectations are more modest, it will take more than 10 years to see a doubling.
The rule of 72 provides a quick calculation to put alternative investment opportunities into context. It also offers a quick estimate of future costs. For example, if you have children (or grandchildren) in elementary school and college costs continue to increase at an 8% rate, college costs will have doubled by the time your children are ready to enroll. Plan accordingly.
For investors, understanding the rule of 72 can be helpful in putting apparently high prices for some companies into context. The key variables are growth rate and degree of confidence that it is sustainable. A company that seems to be growing at a 20% rate would see earnings double in a little more than three and one half years, while a company growing earnings at a 6% rate, would take 12 years to see an earnings double. Since valuations are generally based on the current value of future earnings, the usefulness of the rule of 72 as an analytical tool is evident.
All comments and suggestions are welcome.
Walter J. Kirchberger, CFA