Have you ever wanted to work out the effect of inflation on your savings? Use the Rule of 72. Do you wonder how long it will take for your home to double in value? Use the Rule of 72. Would you like to know an easy way to do compound interest calculations in your head? Yes, you've guessed it. Use the Rule of 72.
The best part is that you don't have to be a mathematician to use the Rule of 72. It's simple, but once you understand how to use it, you'll wonder how you got by without it.
It goes like this: divide the number 72 by the expected rate of return, or by the expected rate of inflation. The answer is the number of years it will take for a given sum to double at the expected compound rate of return, or for your dollar to halve in value at your predicted rate of inflation. Here are some examples.
Your house is worth $700,000 today. You predict it will increase by 7 per cent a year. Divide 72 by 7 and the answer is close to 10. If your prediction is correct, your house will be worth around $1.4 million in 10 years.
You work out that your cost of living is $60,000 a year. You forecast inflation will be 4 per cent a year. Divide 72 by 4 and the answer is about 18. Therefore, you can expect your cost of living to double to $120,000 in 18 years.
You can also use the Rule of 72 as a simple compound interest calculator to check the validity of your forecasts. Let's suppose your home was worth $800,000 today and you guessed that it would appreciate at a steady rate of 5 per cent a year. Is that reasonable? Use the Rule of 72.
Seventy-two divided by five equals about 14. If your calculations are right it will be worth $1.6 million in 14 years, $3.2 million in 28 years, and $6.4 million in 42 years.
Are the figures correct? Yes, they are. But nobody knows if the house values will perform as you have just predicted. If that house is worth less than $3.2 million in 28 years, the capital gain will have been less than 5 per cent a year.
I use the Rule of 72 all the time. Recently, a glossy brochure arrived in the mail extolling the virtues of buying property. It made the confident assertion that "property has always gone up by 10 per cent a year and will continue to do so". Using the Rule of 72 I quickly calculated that a house would double about every seven years (72/10 = 7.2) if it rises by 10 per cent a year. If that's true, let's look at what would happen to the house value we used in the previous example.
In just seven years it would be worth $1.6 million, in 14 years $3.2 million and in 21 years $6.4 million.
You can use your own judgment, but I have grave doubts that a home worth $800,000 today would be worth $6.4 million in 21 years.
You can also see compounding coming into play. For the figures to be true the value has to rise by $3.2 million in the last seven years, but only by $1.6 million in the previous seven years. Every time an asset doubles in value there is more growth in the last double than all the previous doubles combined.
The Rule of 72 can also help you to learn valuable lessons. Most investors believe that if an investment has risen by 35 per cent a year for two years it is virtually guaranteed that it will keep on going up at that rate. Using the Rule of 72 you can work out in a flash that at 35 per cent it will double in value every two years. Imagine the value in 16 years of a $20 share that doubled every two years. It would be a staggering $5120! That is clearly impossible. Wise investors know that a rise of 35 per cent a year for two years in a row is almost a guarantee that the performance in the next few years will be mediocre.
You will find the Rule of 72 a very handy and reliable mental calculation as you start to use it.
Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. His advice is general in nature and readers should seek their own professional advice before making any financial decisions. Email: noel@noelwhittaker.com.au