“Compound interest is the eighth wonder of the world. He who understands it, earns it, and he who doesn't, pays it.” – Attributed to Albert Einstein (although there is no evidence that he actually said it)
"Save and invest, for someday you’ll be 72." – Anonymous
Rule of 72 is a quick way to estimate the number of years it will take to double your investment at a given annual rate of return. It states that you divide 72 (hence the Rule of 72) by the rate, expressed as a percentage.
If you invest $1,000 today and earn 6% per year, it will take approximately 12 years to double your money to $2,000. You simply divide 72 by 6 and get the answer: 12 years.
Of course, you can use Excel or a financial calculator to get the exact number. However, you don’t always have access to these tools and the Rule of 72 gives the result that is close enough to make a quick decision.
Here are a few more examples:
The Rule of 72 is an extremely powerful tool that everyone should know. It is a simple but important tool especially for the younger members of our workforce who are just starting their career.
Now consider this. The average annual return of the S&P 500 Index since adopting 500 stocks into the index in 1957 through 2018 is roughly 8%. So, if you invest $10,000 in the S&P 500 Index fund today, with the long-term rate of return of 8%, the value of your investment will double to $20,000 in 9 years and it will continue to double every 9 years. The following table shows the value of your investment.
The Rule of 72 and the power of compounding is especially important to understand for young investors.
To illustrate, let us take a look at two individuals Ms. Start Early and Mr. Wait Longer. Ms. Early started investing 12.5% of her salary (including the employer match) in her employer’s 401(k) at the age of 25 when she got her first job that offered 401(k). Note that this translates to 1/8th or her first hour's salary each day! Her starting salary was $40,000 and it grew at 3% each year. Mr. Longer earned the same salary but waited 10 years before he started investing 12.5% of his salary. Both of them invested in the S&P 500 Index Fund (such as the one from Vanguard, Fidelity, or Schwab).
The following chart shows the estimated value of their 401(k) each year until they turn 60.
As you can see from the chart above, doubling the saving rate to 25% will enable you to reach $1 million by age 50.
Of course, if your earnings are higher, you will be able to reach these goals much sooner. For example, if your starting salary is $60,000 and it grows annually at 3%, with a 12.5% saving rate, you will reach $1 million in your 401(k) by age 52. With a 25% saving rate, you will reach this goal by age 45.
Note that the above calculations and charts use the long-term historical stock market rate of return of 8%. Future rate of return may be different.
Here are some additional points to keep in mind.
Invest in low-cost index funds (or equivalent ETFs) such as Total Stock Market Index (Vanguard Total Stock Market Index Fund) or S&P 500 (Vanguard 500 Index Fund).
Stay the course in the good and bad markets to take advantage of dollar cost averaging. Remember that the stock market does not go up in a straight line, but in the past, it has always gone up over time. Time in the market beats timing the market.
The rule can work against you if you borrow on credit cards and personal loans instead of investing.
