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Tuesday, February 20, 2024

What is the rule of 72?

What is the rule of 72?

02.06.2022

My daughter is turning 10 this month. I’ve been absolutely in love with my little girl from day one. Her smile, family-first nature and sense of humor have always made me proud to be her father.

Becoming a dad was what turned me into a more serious investor. When you’re caring for little humans, living for today isn’t always the best strategy.

In the beginning, investing (like parenting) was very confusing. I had no idea what I was doing.

There was complex jargon about stocks, bonds, mutual funds, 401k matches and investment brokers not disclosing how they were paid. It felt like the industry was set up for the little guy to lose.

It was around that time that I decided to keep things as simple as possible with my investing journey. I wanted to find ways to take all the noise and boil it down into language I understood.

In my quest to simplify investing, I came across the Rule of 72. Be sure to keep in mind that while it is not reasonable to think you can double your assets in the times shown below, the Rule of 72 does illustrate the power of compound earnings and how it can potentially affect your savings for retirement. Also keep in mind that rates of return may vary.

What is the rule of 72?

The Rule of 72 helps you determine how long it might take for your money to hypothetically double. It’s worth noting, the “rule of 72” definition isn’t necessarily perfectly accurate because past market results do not predict future market behavior. However, it’s a “back of the napkin” way to determine where your portfolio might potentially be in the years ahead.

The rule of 72 formula

There are a couple of valuable calculations you can use to determine different factors in the rule of 72.

Expected Rate of Return: 72 / Years to Double

I think the most useful is likely the calculation that gives you an expected rate of return for a given period of time.

For example, let’s go back to 30-year old Andy (with his new Dad-strength) as he’s becoming a more serious investor. With a net worth now in positive territory, he’s focusing on investing in a Roth IRA because his company is not matching his 401k contributions and their investment options are sub-par.

His Roth IRA now sits around $10,000.

Using the Rule of 72, and assuming a 10% rate of return on his investments, 30–year-old Andy could expect his investment balance to double in 7.2 years. His $10,000 could turn into $20,000 around his 37th birthday (without any further contributions).

The math behind this rule of 72 calculation is as follows:

  • Calculation: 72 / Rate of Return = Years to Double
  • Example: 72 / 10% = 7.2 Years to Double

FOR ILLUSTRATIVE PURPOSES ONLY. This hypothetical illustration does not reflect a particular investment and is not a guarantee of future results. The rule of 72 is a mathematical rule used to approximate the number of years it takes a given investment to double in value. Rates of return may vary.

Of course, Andy should definitely consider adding additional contributions to his Roth IRA over the coming years and decades to truly maximize the benefits of this tax advantaged retirement option.

How the rule of 72 helped me become a better investor

One of the reasons I like The Rule of 72 so much is that it emphasizes the power of compound earnings over time. Let’s take the same example of growing my Roth IRA, but let’s extend the timeline to a more traditional retirement age.

  • 2012 (age 30): $10,000
  • 2019 (age 37.2): $20,000
  • 2026 (age 44.4): $40,000
  • 2033 (age 51.6): $80,000
  • 2040 (age 58.8): $160,000
  • 2048 (age 66): $320,000

*Assuming 10% investment returns every year. Rates of return may vary.

Maybe it’s just me, but there’s something about seeing compound earnings rates in action that makes my jaw drop. The $10,000 deposit crosses over the $300,000 mark with no additional contributions!

Realizing the power of compound earnings and time, I try to remind myself of my choice investing strategy: patience. Simply waiting and letting the market do the heavy lifting for my retirement portfolio has been (and will continue to be) my way to a comfortable future. Of course, you still have to keep an eye on your investments and make changes when needed, such as when there are life changes like having a child or when you need to rebalance your investments.

And that comfortable future doesn’t just apply to my retirement. It also can apply to my daughter’s future as well.

This Rule of 72 has proven to be more than true for my daughter’s 529 college savings plan. We started her plan with an initial $10,000 deposit as well when she was born. 10 years later, the account balance is over $50,000. It has more than doubled due to time, compound earnings and additional contributions.

Why the rule of 72 helps me relax

In the previous calculations, we showed how 30-year-old Andy could take his initial $10,000 deposit and potentially get to over $300,000 by age 66. What we didn’t show in that calculation is how additional contributions can potentially grow that balance over time.

After contributing to my Roth IRA over the past 10 years, my account balance now sits around $120,000. This is much higher than if I would have simply let time and compound earnings do its thing.

I worked hard in my career, grew my income and contributed part of that income to my Roth IRA. There were even a few years that I maxed out my contributions.

And now, I don’t plan on contributing much to my retirement accounts going forward.

You know why? The Rule of 72. 

Let’s run those numbers again with 40-year-old Andy:

  • 2022 (age 40): $120,000
  • 2029 (age 47.2): $240,000
  • 2036 (age 54.4): $480,000
  • 2043 (age 61.6): $960,000

*Assuming 10% investment returns every year. Rates of return may vary.

The Rule of 72 is telling me that if I simply do nothing, and my investments earn 10% every year, I can likely anticipate almost $1,000,000 in my Roth IRA portfolio before 62 years old. But keep in mind that rates can vary and there can be times when the value of the account can go down.

Well, can we retire with $1 million, you might ask?

For our family, we’re going to need around $2-3 million in retirement (factoring in our comfortable cost of living and inflation). Given this, we’ve also been investing in workplace 401ks, my wife’s Roth IRA and even an HSA.

With all those combined (and not adding another dime), we project to be well over $3 million by our desired retirement age. Using the 4% rule, that’ll give us around $120,000 per year in income.

And as for my daughter’s 529 college savings plan, the Rule of 72 shows us she may potentially have around $100,000 when she’s 17.

I love math.

Final thoughts on the rule of 72

As with all “back of the napkin” math problems, the Rule of 72 should not be taken as a perfect solution to your investing worries. Keep in mind it is only a mathematical formula that helps determine how long it hypothetically takes for your money to double. It emphasizes the power of compound earnings over time and is not a guarantee of success. Using the free financial dashboard from Empower can help you get a much better look at your asset allocation and rate of return so you know where you stand.

Also, meeting with a financial professional who knows your particular goals and your unique situation can be a smart move, too. That’s when you can really bring the Rule of 72 to life.

Looking ahead another 10 years, I hope to see that my daughter will be off to college with the majority of it hopefully paid for, and my wife and I working out the details of our retirement.

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Andy Hill

Contributor

Andy Hill, AFC®, is a husband and father of two kids. His personal finance goal: To give his family the best life possible and strengthen their family tree for generations to come. In 2016, he launched Marriage Kids and Money, a blog and podcast about young family finance. In 2020, he and his wife achieved a personal goal of becoming millionaires in less than 10 years. Now, he thrives on helping others do the same.

 

 

Author is not a client of Empower Advisory Group, LLC, and is compensated as a freelance writer.

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