I thought I would take a break from covering some more complex tax-related items and instead head back to the basics. Now, what could be more fun than the power of compounding!
I won’t bore you with the facts of how big a piece of paper would be if you could fold it over onto itself 50 times. I mean, you probably remember that factoid from the article I wrote some years ago about the power of compounding. Okay, the answer is 60 million miles thick! You know, the distance from the earth to the sun. Instead, I am going to keep is simple by doing a refresher on the Rule of 72.
Just to be clear, I’m not talking about 72T, also known as SEPP, that allows you to take distributions out of your IRAs early without penalties. Nor am I talking about the new age for Required Minimum Distributions. No, what I’m talking about is the simple calculation of how long it takes for an investment to double based on its rate of return.
Let me be clear that the rule of 72 isn’t really a rule. It’s more of a guideline as it isn’t exact. But, as the expression goes – “Close enough for government work.”
Here’s how it works. Take the number 72. Then divide it by your rate of return. This will then get you close to how long it will be before your investment has doubled in value. For example, you invest $1 and are enjoying a 9% rate of return. Well, it will take 8 years for the $1 to turn into $2. Technically it will take 8.04 years.
It gets a little less exact the more your rate of return moves away from 9%. A 100% rate of return takes one year to double. If you were to follow the Rule of 72 you would calculate it to take .7 years. On the other end, if the Rule of 72 were exact a 2% rate of return would take 36 years to double. In reality it takes 35 years, so a full year off.
Regardless, the Rule of 72 is a simple way to estimate how long before your investment may double. Now, don’t get too greedy with your rate of return assumptions. I remember years ago after my mom passed we were sitting down with her bonehead advisor. This was before I entered this profession and it was during the hay days of the dot.com melt up. He was telling us we should assume our investments doubling in 3 years based on the S&P500 returns in the late 90s. But hey, it’s your life so I guess you can make any rate of return assumption you want to.
Obviously you can keep this calculation going to see how your investments would do over a longer period too. You know, what happens to that $1 at a steady 9% rate of return for 16, 24, 32, 40 or more years. Actually, this is probably a great thing to do with your kids to help them understand the power of compound interest. While I don’t think Einstein ever said it was the most powerful force in the universe, it is eye-opening.