The Rule of 72 And Investment Time Frames
One of the fundamental principles of investing has been called, by Albert Einstein, the most powerful force in the universe. Compound Interest.
The basic principle of compound interest is that by allowing someone else to use money you’ve given them, they’ll pay you a certain percentage of your initial investment at the end of each year; by letting this amount that they’ve paid you add to your original amount, your money grows.
The formula that’s used to determine a compound interest equation is called the Rule of 72: If you divide 72 by the percentage rate of return, you’ll derive the number of years needed for your initial investment to double. For example, if you’re getting a 6% interest rate, 72 divided by 6 is 12 it will take 12 years for the interest to accrue to turn an initial $1,000 investment into a $2,000 investment.
Now, in practice, you need to adjust your investment percentage for historical inflation rates; interest rates will rise in response to inflation rates. Raising and lowering interest rates on the Federal Reserve level is one of the key factors in adjusting the economy in response to inflation. The most straight forward (and conservative) method of adjusting for inflation is to take the publicly announced inflation rates, add about 1% to them, and deduct that from your rate of interest. This will give you an inflation adjusted interest rate to work from. (The reason you add 1% to the inflation rate given is because the way inflation figures get reported got changed in the late 1980s, and it now under-reports the real inflation rate.)
So, if the published inflation rate is 1.5%, that gets treated as 2.5%. Subtract 2.5% from the 6% we used in our earlier example, and that leaves 3.5%. 72 divided by 3.5 = 20.57 years for your initial investment to double, which is a long stretch of time; that’s 20 years and 7 months, in round numbers.
What this does is highlight the importance of getting a good interest rateand highlights one of the important benefits of the stock market and stock funds. Historically, the stock market, over the trend of decades, gets a rate of return of about 8 to 10%. More importantly, because stock prices rise with inflation, a buy-and-hold strategy for stocks means that your inflation adjustment is already happening holding stocks at 9% means that your initial investment is doubling in 8 years, rather than 20 and a fraction.