Recently I was invited by a former ag retailer and farmer to conduct an investing workshop for a group of his family and friends. I was once again surprised by how few had heard of the “Rule of 72.” While working through this simple formula someone asked, “Why don’t they teach this in school?”
Given the importance of basic financial literacy, it seems a valid question. I would readily admit I am far removed from the education system and don’t really know what is being taught; however, based on what I have observed there seems to be a lack of such skills. With that preamble, I thought it worth stepping back to a couple investing basics. The Rule of 72 is a simple mathematical oddity that works. If you divide the rate of return into 72, that’s how many years it will take to double your money. If you earn a three per cent return it will take 72÷3, or 24, years to double your money. If you earn six per cent you will double in 72÷6 or 12 years, and if you earn 12 per cent you will double in six years.
I use those numbers for illustrative and easy math, but they are also fairly reflective of the very long-term returns on cash, bonds and stocks of 3.4, 4.7, and 9.5 per cent respectively. While 12 per cent will be scoffed at by many as an unrealistic return rate, my personal record is very close to this.
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The second part of the simple math exercise is this: if you invest $1,000 when you are 20, how much will you have at a retirement age of 68? I am again using this 48-year timeframe for easy and illustrative math.
If it takes 24 years to double, then an investor will achieve two doubles or $1,000 x 2 x 2 = $4,000. If it takes 12 years to double, then the investor will double four times or $1,000 x 2 x 2 x 2 x 2 = $16,000. If it takes six years to double, the investor will achieve eight doubles or $1,000 x 2 x 2 x 2 x 2 x 2 x 2 x 2 x 2 = $256,000. This is the power of compounding.
The third part of this simple math exercise is to recognize that long-term inflation has run about three per cent. Investments are impacted by inflation and taxes. There are far too many nuances around taxes to address but we can easily factor in inflation. This historical inflation rate would take a three per cent return to a zero real rate of return, a six per cent return to a three per cent real rate, and a 12 per cent return to nine per cent. Therefore, the first investor after 48 years would have his original $1,000 but that’s all. The second investor would have two doubles, or $4,000 and the third investor would take 72/9, or eight years to double, and in 48 years would achieve six doubles, or $1,000 x 2 x 2 x 2 x 2 x 2 x 2 = $64,000 real return. Which outcome would you prefer?
The “cost” of saying you would prefer the latter outcome is the learning that is required — and the fluctuations that need to be endured.
Happy returns
Calculating your personal return rate is another simple but critical step to take. I do this across all TFSA, RRSP and taxable accounts at year-end. If you haven’t done this before, it would be a worthwhile exercise to go back as many years as possible. Most internet investing sites calculate return rates, but I believe some learning will occur if calculated on your own.
If someone started the year with $10,000 and ended the year with $12,500, the gain would be $2,500÷$10,000 invested, or 25 per cent. However, we must also account for fund flows in or out of an account. This makes the math a little more difficult, but still relatively easy. Let’s work through an example of how I do it.
If an account starts with $10,000 on Jan. 1, and you add an additional $2,000 on May 1, but take $1,000 out on Nov. 1 and end up with $12,500 at year-end, what return rate has been achieved? We must calculate the gain, as well as the average amount invested during the year. The gain is easily calculated: $12,500 – ($10,000 + $2,000 – $1,000) = $1,500.
The average investment is more difficult but still straight-up math. We had $10,000 invested for 12 months, an additional $2,000 for eight months and subtracted $1,000 for two months. The average is: $10,000 x 12 + $2,000 x 8 – $1,000 x 2, all divided by 12 months. This works out to $11,167 average invested over the year. Our gain was $1,500 so our return rate was $1,500/$11,167 equals 13.4 per cent.
In school, oh so long ago, I always preferred math over English, so it comes more naturally to me. However, both those important math exercises should be within the grasp of most individuals — and I see no reason why they couldn’t be taught in school.
