The Rule of 72... and an interesting corollary for monthly savers!
Has it always been your dream to solve complicated compounding problems in your head? Well, probably not, but it’s a useful skill to have nevertheless! This week, we present a simple, lightning fast benchmark to determine how good (or bad) an investment option is.
The Rule of 72
The simple “Rule of 72” basically states that in order to arrive at the number of years it’ll take you to double your money at a given annual compound interest rate (say X%), all you need to do is divide 72 by X, and voila – there you have your answer!
For instance – if your investment fetches you a compound annual interest rate of 10%, it’ll take you 72/10 = 7.2 years to double your investment. To be exact, a 10% CAGR investment will take you 7.3 years to double your investment – so it’s really remarkably accurate.
The reverse applies too…
The reverse of the above applies as well – meaning that if your investment doubles in “X” years, the effective annualized return (CAGR) equals “72 divided by X” percent. For example – the recently re-launched Kisan Vikas Patra (KVP) doubles your money in 8 years and 4 months (8.33 years). Divide 72 by 8.33 and you’ve got the effective performance of the KVP – 8.67% per annum. Armed with this information, it becomes that much easier to compare the KVP to other investment avenues within similar risk categories.
It’s important to note that the Rule of 72 is a basically a rough estimation, and the accuracy diminishes as the return percentages or number of years becomes large. Also, the Rule of 72 applies to lumpsum (one time) investments only.
A useful practical application
A number of investment products do not clearly specify an annualized return, but rather “disguise” their performance by specifying that “your money will double in X years”, making it difficult to make informed decisions about the product. For example, a “child insurance plan” may promise to double your investment by the time your 6 year old child turns 18 years old (in 12 years’ time). Armed with the Rule of 72, you can now quickly calculate that the effective performance is 72/12 = 6% per annum.
But what if you’re a regular (monthly) saver and not a lump sum investor?
As mentioned earlier, the Rule of 72 has practical applications for lump sum investments only. How then can you judge the performance of monthly savings options (such as recurring deposits or mutual fund SIP’s) in the same manner? For this, we’ve devised the ingenious “FinEdge Rule of 128 ®”!
Let’s say that a specific recurring deposit specifies its performance in the following manner – “Save Rs. 10,000 per month for 15 years and receive double your money saved in the 16th year”. What is the CAGR? Easy as pie – simply divide 128 by the time period (15 years) – and there you have the answer: 8.33%!
As with the “Rule of 72”, the “FinEdge Rule of 128” has a reverse application as well. Let’s say you’d like to save Rs. 6 Lacs over 10 years in equal monthly installments (of Rs. 5000). What return do you need to generate in order to double the 6 Lacs to 12 Lacs? Simply divide 128 by the number of years (10 years) and there you have it – 12.8% CAGR!
In the above example, what if the number of “saving years” changes to 8 instead of 10? Firstly, the monthly savings amount will change to Rs. 6250 (6 Lacs divided by 96 months instead of 120 months). And applying the magic rule of 128, you’ll need a CAGR of 128/8 = 16% CAGR to double your 6 lacs to 12 Lacs in 8 years. It works every time! Do keep in mind that just as with the Rule of 72, the “FinEdge Rule of 128” is a rough estimator, and the accuracy diminishes as the numbers get larger…
So there you have it – two interesting thumb rules that can help you compare and judge investment options, or at the very least, impress your friends! Happy investing.