Exponential growth is an important concept in investing. Compound interest, or the interest you earn on the interest your investments generate, adds up over time and represents a significant contribution to your retirement savings.
However, calculating how quickly an investment will grow with compound interest can be complex. You can use the rule of 70 to simplify these calculations.
We should note that this should not be confused with the Rule of 78, which is a method used to charge interest on a consumer loan. The early years of the loan are mostly interest which makes early payoff less advantageous because you’re just paying interest up front and not paying down principal as much as you would otherwise expect.
What Is the Rule of 70?
The rule of 70 is a simple calculation that tells you how long it takes for an investment to double in value at a given rate of return.
You need to know the estimated annual rate of return on an investment vehicle or portfolio. Take 70 and divide it by the annual rate.
The result is the number of years it will take for the investment to double in value. It’s not an exact calculation, but it gives you an estimate.
For instance, the average return for US mid-cap stocks was 11.5% in 2020. If you were to invest $1,000 in an index fund that tracks the S&P Mid-Cap 400 Index and the rate of return stayed consistent over time, it would take a little over six years for your investment to double (70 divided by 11.5).
What Is the Rule of 72?
The rule 72 is a similar calculation. Instead of using 70 and dividing this number by the annual rate of return on an investment, you can use 72.
How does the rule of 72 work? Let’s first take a closer look at the math behind the rule of 70.
This simple calculation gives you an estimate of how long it takes for an investment to double in value because of logarithms. A logarithm is a number that corresponds to the power to which you need to raise a base number to obtain a given number.
Since we want to know how long it takes for an investment to double, we need to use the logarithm of two, which is 0.693147. And because we’re working with annual interest rates in percentages, we would use 69.3147%. It’s much easier to round this number up to 70.
Because the purpose is to get an estimate, numbers don’t have to be precise. By using 72 instead of 70, we can work with a number that is divisible by a broader range of numbers to get a result that is more likely to be round.
For instance, let’s say an investment has an annual rate of return of 6.4%.
If you use the rule of 69.3, you will get 10.828125 years. If you use the rule of 70, you will get 10.9375. You can obtain the number 11.25 when you use 72 instead, which is a lot easier to work with when doing your calculations.
Even though there is a difference between these three results, it translates to only a few months difference when planning for long-term wealth management and retirement.
How to Get More Precise Results With the Rule of 72
You can tweak the numbers you use to get more accurate results. For investments with interest that compound daily, it’s best to use 69.3.
The rule of 72 works best for investments with an annual rate of return between 6 and 10%. It will not work for investments with a negative rate of return, and it becomes less accurate as the return gets further from the 6 to 10% range.
You can get a more precise result if you add or deduct one from 72 for every three percentage points that you gain or lose from the base of 8%. For instance, you can use 71 for an investment with a 4 or 5% rate of return or use 74 for a return of 14%.
What Does the Rule of 70 Mean for Investing?
Even though it’s an approximation, the rule of 70 is a valuable tool for long-term wealth management and retirement planning. Here’s how you can use it.
If you’re still at the beginning of your retirement planning process, you can use this rule to assess how long it will take for your entire portfolio to double in value. You can then ask yourself if you’re on track to retire when you want to.
The rule of 70 can help you set your retirement age. If you know how much money you need to retire comfortably, use the rule of 70 to get an idea of how long it will take to reach your goal at your current rate of return.
An essential part of planning for retirement is deciding how you want to allocate your assets. Some products have a higher return but might carry a higher risk. The rule of 70 or 72 is a useful tool for comparing two or more investment vehicles.
Let’s look at more rule of 72 examples. You can allocate your assets between a low-risk product with a return of 5.5% or increase your risk exposure and invest in a product with a return of 7%.
If you apply the rule of 72, you will find that the first investment will double in 13.09 years while the second riskier investment will take 10.2 years to double. You can then decide if gaining three years is worth taking the higher risk.
You can also use the rule of 70 to get an idea of how quickly inflation will grow at the current rate. This calculation will tell you how many years it will take for the dollar to lose half its value. It’s a calculation you can use to see if returns from your portfolio will outpace inflation or not.
Conclusion
The rules of 70 and 72 are useful tools for comparing investments or assessing how quickly your portfolio can grow. While these calculations are estimates, they greatly simplify your calculations.
Castle Wealth can help you plan for the future by putting together a personalized financial plan aligned with your goals. We will keep track of how your investments perform and adjust your asset allocation as needed to help you meet your retirement goals. Contact us to learn more!
