Whenever a friend tells me they are headed to Foxwood or Atlantic City for the weekend, I jokingly tell them: “Be sure to double your money“.
Going to the casino for entertainment is fine but gambling as a financial plan is flawed. You are more likely to lose your money at the casino than to double it. To quote DMX:
When you are in the house, you play by house rules
Two words you’ll never hear is “house lose”
The components of proper financial planning are a horizon of years weighing risks, objectives, and expected return. One investing heuristic is the “rule of 72”. This back-of-the envelope formula estimates how long an initial capital outlay doubles given a constant rate of return.
- use the number 72 as your numerator
- use your annual return rate as your denominator
- divide the numerator by the denominator to determine the number of years it will take for your investment to double
The table below shows the time to double principle for returns compounded annually.
| Compound Annual Growth (CAGR) | CAGR /72 | Years to Double |
|---|---|---|
| 1% | 72.0 | 2.05 |
| 2% | 36.0 | 2.04 |
| 3% | 24.0 | 2.03 |
| 4% | 18.0 | 2.03 |
| 5% | 14.4 | 2.02 |
| 6% | 12.0 | 2.01 |
| 7% | 10.3 | 2.01 |
| 8% | 9.0 | 2.00 |
| 9% | 8.0 | 1.99 |
| 10% | 7.2 | 1.99 |
| 11% | 6.5 | 1.98 |
| 12% | 6.0 | 1.97 |
| 13% | 5.5 | 1.97 |
| 14% | 5.1 | 1.96 |
| 15% | 4.8 | 1.96 |
| 16% | 4.5 | 1.95 |
| 17% | 4.2 | 1.94 |
| 18% | 4.0 | 1.94 |
| 19% | 3.8 | 1.93 |
| 20% | 3.6 | 1.93 |
| 21% | 3.4 | 1.92 |
| 22% | 3.3 | 1.92 |
| 23% | 3.1 | 1.91 |
| 24% | 3.0 | 1.91 |
| 25% | 2.9 | 1.90 |
Two years is 24 months. In the table above, from 1% to 25%, the actual doubling time ranges from 22 months to 25 months. Continuous (instead of annual) compounding would result in the numerator being adjusted to 69.3 instead of 72. While more accurate, it is harder to calculate.
Calculators, spreadsheets, or logarithm calculus can generate accurate figures. This concept demonstrates the value of compounding and the value of long-term investing.
The rule of 72 can be used to estimate how long it would take for, say:
- credit card debt to double given the nominally charged interest
- currency to halve given inflation
- investment to quadruple
The outstanding balance on a credit card that charged 21% interest would double in three and a half years (that is 72/21 = 3.4). Fiscal prudence prioritizes getting rid of high-interest debt.
An economy with 12% annual inflation would have its currency devalued by 50% in six years. Inflation of 2% would lead to currency halving in 36 years. The pain of inflation is experienced both at the store register with each purchase as well as with the dwindling purchasing power of savings over the longer term.
An investment that yields a 9% return would double from years one through 8. From years 9 to 16, it would double again, or quadruple over the 16-year period.
What to take away from the Rule of 72?
The fable of the Tortoise versus the Hare reminds us that slow and steadfast can beat fast but unfocused. We can incorporate those lessons and the Rule of 72 into our personal race towards financial stability.
- Focus on eliminating costly debt
- Invest early and steadily to take advantage of compound earnings
- Do not lose sight of your financial goals
- Develop disciplined spending habits
We will use a fictional character, Johnny, to illuminate how implementing these four objectives in unison can get you across that finish line.
- In his last year of college, Johnny accumulated $5,000 of debt on his credit card
- His limited income enabled him to pay only the minimum balance
- After graduating from college, Johnny gets his first full-time paying job
- Every workday, he stops off at the cafe and enjoys a $5 cup of coffee
- Each workday, he goes out to lunch with his office mates and spends $15 per meal
- Twice on the weekend, Johnny goes out, spending $50 on each occasion
To summarize, in his first year of working, his routine habits cost him $200 per week (that is 5 * $5 + 5 * $15 + 2 * $50) and he’s unable to make any dent on his credit card balance, charging him 2% per month or $100 in interest.
Johnny takes a lesson in financial literacy and replaces his $5 cafe coffee with brewing at home that costs him $0.25 per cup. He lowers his average daily lunch-spend from $15 to $10 through a combination of occasionally packing lunch or eating at a less expensive outlet. He limits going out on the weekend from twice to once.
In total, Johnny lowers his weekly spend by $98.75 (that is 5 * $4.75 + 5 * $5 + 1 * $50).
In his second year of working, Johnny allocates his weekly savings 100% to reduce his credit card debt. In about a year, he has no credit card debt.
In his third year of working, Johnny directs $495 per month into a savings account that earns 1% interest. That is 4 * $98.75 from his weekly savings $100 in interest savings from eliminating his credit card debt.
In his fourth year of working, directs $6,000 per year (that is $495 * 12 or $5,940 plus $60 from another source) into an IRA that averages a 6% compound rate of return on his investment for his next twelve years of employment. If we average the first-year principle of $6,000 with the 12th year principle of $12,000, each year invested has an average value of $9,000. That figure of $9,000 times 12 indicates that his future balance will be $108,000. If you do the math, the calculated number is $107,293 – close enough.
We can compare Johnny’s personal balance sheet after twelve years with the changes in his spending and saving habits.
| Credit Card Debt | Weekly Spend | Monthly Interest | Monthly Investment | Debt Year 12 | IRA Year 12 |
|---|---|---|---|---|---|
| $5,000 | $200 | $100 | 0 | $5,000 | 0 |
| $5,000 | $100 | 0 | $500 | 0 | $107,923 |
The projections show net worth increasing by over $110,000. This example simplifies many things – such as constant interest rates, steady employment, unplanned surprises, and no accounting for inflation impacts. You may need to further educate yourself to appropriately compare levels of risk or even tax impacts. Certain strategies might be easier to achieve with professional advice or automated actions. That said, the simple guideline of being disciplined with your habitual spending, paying off expensive debt first, and investing regularly for extended periods is useful guidance.
Taxes, Penalties and Other Real-World Nuances
Taxes are a reality of life. But don’t overdo it as Robert Cray lamented in his track 1040 Blues:
Worried? You betcha!
Discouraged? I don’t know.
Every time I see a 1040
Out of my pocket it goes.
Total returns are impacted by taxes; therefore, it pays to be strategic. Be aware that tax avoidance and tax evasion are not the same thing. A tax-advantage vehicle might refer to an instrument that lets you invest with pre-tax dollars (as in a 401K) or waives taxes on investment returns (like an IRA). Withdrawals might be subject to rules-based restrictions, such as age or hardship. Early withdrawal might prompt withholdings or penalties.
Whether you are saving for the future or paring down debt, be realistic about the time needed to reach your objectives. Rome wasn’t built in a day. Craft a well-thought plan and stick to it.