One of the most fundamental investment principles is the “Rule of 72.” Understanding this rule is key to understanding investment returns, the benefits of tax-advantaged accounts, and why starting with limited funds can still lead to great outcomes.
The year 1972, for those of us old enough to remember, was a year that will forever be etched in our minds as the most important year in hockey history. It was the year of the famous Summit Series between Canada and the former Soviet Union. With our best players in the NHL not allowed to compete in the Olympics, the Summit Series was organized to determine true hockey supremacy. The dramatic eight-game series was down to the wire when Paul Henderson scored with just 34 seconds remaining in the eighth game.
Seventy-two is also an important investment number that should always be etched in our minds when we think about investment returns. I am perpetually surprised by how few people know the “Rule of 72,” as I have known it since I was a youngster, probably before the 1972 Summit Series. It’s another one of those little secrets, and is just a very simple mathematical formula: 72 divided by the annual rate of return equals the number of years to double your money. I don’t know why it works, but it does, and is a great way to approximate the value of a current investment at some point in the future.
If you go to the bank and buy a $10,000 GIC (Guaranteed Investment Certificate) at two per cent interest, it will take 36 years to double your money (72/2 = 36). In 36 years that certificate will be worth $20,000.
If you buy stocks and achieve 12 per cent annual returns, you will double your money every six years (72/12 = 6). In the same 36-year period you will experience six doubles: $10,000 x2x2x2x2x2x2 = $640,000. Many will argue that 12 per cent annual returns aren’t realistic but I have achieved 11.7 per cent over 25 years in my RRSP and have other accounts ranging from nine to 17 per cent with shorter timeframes. Even more modest nine per cent annual returns will provide an outcome of $160,000 versus $20,000.
Let’s look at another scenario: How much difference will there be between six and eight per cent annual returns, over 36 years? The seemingly small two per cent difference compounds to represent twice the difference in outcome. The money doubles every nine years with eight per cent returns (72/8 = 9), for four doubles in 36 years. With six per cent returns the money doubles every 12 years (72/6 = 12), for three doubles in 36 years. Therefore with eight per cent returns, $10,000 would become $160,000 ($10,000 x2x2x2x2), but with six per cent returns, just $80,000 in the 36-year period.
Equity mutual fund fees range around two per cent, and two per cent could also be comparable to the difference in a tax-advantaged account versus a taxable account. Two per cent mutual fund fees in a taxable account would exacerbate the situation. Go ahead and calculate the difference between eight and four per cent over 36 years.
The “Rule of 72” can also be used to calculate other compounding factors. If inflation averages two per cent what will a $10 item cost in 36 years? If canola yields increase three per cent per year and are 40 bushels today, what will they be in 24 years? If you increase your farm size by 10 per cent per year, how big will it be in 14.4 years?
The compounding effect of the “Rule of 72” is why I am such an advocate of:
- Stocks over lower-return investments, while accepting the volatility of stocks.
- Investing over speculating, as nine to 12 per cent annual returns builds significant wealth over time. Reaching for higher returns on speculations often leads to disappointment.
- The younger you start the better.
- Starting with small amounts, and contributing regularly.
- Managing your own money (while not the answer for everyone), as saving fees can lead to big differences in outcomes.
- Tax-advantaged accounts.
Answers: $20.00, 80 bu. and 4 times the size.