Do you find understanding the math associated with investing complicated or maybe a bit “fuzzy”? A bit like understanding algebra or geometry back in high school for the first time.
If you’re like most individuals understanding the relationship between the money you have, investing it and then determining how much money you can make can be rather confusing. Let’s face it, some financial calculators designed to help you understand the impact of investing your money can actually complicate the whole process.
Fortunately, there is a simple calculation you can use to take a “first blush” at understanding how much money you could potentially make with an investment, and it doesn’t require a financial calculator or a Ph.D. in mathematics.
The Rule of 72
The Rule of 72 is a simple mathematical formula used to determine how long it will take to double your money, based on a specific annual rate of return. It works like this.
If you have $1000 earning a rate of return of 2%, simply divide 2 into 72 to determine how long it will take to double your money.
72 / 2 = 36
It will take 36 years at a 2% rate of return to double your money ($2000). Seem like a long time? What if you could earn a 9% rate of return?
72 / 9 = 8
A 9% rate of return will double your money in 8 years.
Simple right? But now what?
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When to Use the Rule of 72
Although The Rule of 72 is simple it isn’t a perfect mathematical calculation. As the rate of return becomes higher the accuracy of the calculation becomes less precise – but only by a few months. Using a financial calculator or investment tool is the best way to accurately calculate the number of years it takes to double your money.
However, the Rule of 72 calculation is still valuable if you want to do a quick analysis and understand the overall impact a rate of return has on your money. And as a means of understanding the big picture of investing, and how your money can work for you.
In the example above, if you’re stashing cash in a Certificate of Deposit (CD) at your local bank earning a 2% rate of return will obviously take you a long time to double your money (36 years). However, move that cash into a mutual fund earning a 9% rate of return and you can quickly see how a higher rate of return will allow you to double your money in a shorter period of time (8 years).
Based on your financial goals, retirement timeline and your propensity for risk, you can then ask yourself the next question, “Is a CD the best place to stash my cash?”
The Rule of 72 is a simple financial calculation and shouldn’t be used to make long-term financial decisions, but it can provide you with an initial evaluation of what your money could do for you. Use it as a first step to understanding the relationship a rate of return will have on your ability to double your money.
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Have you used the Rule of 72? Comment below.