Successfully meeting your goals means knowing some important basics -- like how much money you should invest, how long it will take, and what average rate of return you can feasibly achieve. The better you can answer these questions, the easier planning for your goals can be.
Figuring these numbers out can be intimidating, though. If setting goals is difficult for you because the process seems too hard, this popular rule could get you on the right track.
Rule of 72 defined
The rule of 72 is a straightforward way that you can calculate how long it will take for your money to double based on an average annual rate of return. Using the rule, you take the number 72 and divide it by this expected rate.
For example, if you have a $10,000 investment that has earned or that you anticipate will earn an average of 10% every year, it would take 72/10 = 7.2 years for your money to double. The more conservatively your money is invested, the longer it will take to double your money, and the more aggressively it's invested, the shorter a time it should take. If you earn 12% on average, this rule calculates that your money doubles in 72/12 = six years. If you earn on average 8%, your investment should double in approximately 72/8 = nine years.
Rule of 72 based on different asset classes
You can get a general idea of how different asset allocation models have performed over the years by using historic rates of return. During the 90-year period of time between 1929 and 2019, this is what the rule of 72 looks like for these different mixes of stocks and bonds.
|Asset Mix||Average Rate of Return||Years to Double|
|30% stocks/70% bonds||
|60% stocks/40% bonds||
Pros of the rule of 72
The biggest positive of using this rule is that it is incredibly simple. You don't need a fancy financial calculator or computer program, just a sheet of paper, a pen or pencil, and basic math skills.
You can then set some rudimentary goals using your calculations. Let's say that you have a goal of saving $50,000 for your child's education in 18 years. You have $12,500 that you plan on investing now. You would ideally like that to double to $25,000 in nine years and $50,000 in 18 years. Using the rule of 72, you could figure out what average rate of return will accomplish this. After calculating this rule, you learn that it is 8%, and can invest your money accordingly.
Limitations of the rule of 72
If you invested in 100% stocks over 90 years, your average rate of return would be just over 10%. In general, the longer you give your money to grow, the better a chance you have of capturing these sorts of averages. But over short periods of time, you may find that your averages fluctuate more and aren't as predictable.
The average returns you get from the stock market also depend on the time span that you invested and can vary. For example, if you invested in the SPDR S&P 500 ETF (NYSEMKT:SPY) over the last 15 years, over a five-year period of time, you would have earned 15.12% on average. Over 10 years, that average return would be 13.49%, and over a 15-year period of time, 9.53%.
But if you had invested your money in the same ETF starting in 2000, your results would be very different. Having experienced both the dotcom bubble, your five-year average would be -0.71%. The Great Recession would also have hurt your returns, making your 10-year average 1.2% and your 15-year average 6.09%.
Using this rule could also make investing just for a higher rate of return tempting so that you will have a shorter doubling period. But the higher the rate of return, the more volatile the investment could be. If you fall into this trap, you may find that your portfolio isn't invested in line with your risk tolerances, which could make staying the course during bear markets difficult. If you're unable to do so because your investments are too aggressive, the numbers you calculate are invalid.
The rule of 72 can help you make quick and easy calculations that can help you set goals and start the financial planning process. But given its limitations, you should probably follow it up with some more extensive planning. You should also make sure that you're reviewing your accounts on a regular basis, like annually, so that you can account for extremes in the stock market either way and make adjustments accordingly.