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Rule of 72:

“The most powerful force in the universe is compound interest” is often quoted in reference to Albert Einstein. Yet many scholars believe that the man never uttered the words and the line was a simple catch phrase used frequently in financial presentations to catch the attention of novice investors.

It’s important to realize that compound interest isn’t some gimmick or sales pitch from a mutual fund company in order to help sell you something. It’s not an invention by someone who sat down & realized what they could do with numbers; it’s real. For many investors it’s something that they fail to recognize as having the potential to impact their portfolio in a dramatic way. It’s also not a complicated formula that you need a mathematics degree in order to decipher; it’s just simple numbers.

Many people never realize that the “Rule of 72” is actually what we all ask ourselves or others when we ask the question “How long until my money doubles?” That’s essentially what the tool is used to figure out.

First you need to understand the simple method of how compound interest works:

If you borrow $1000 at 5% annually, then the interest on that principle is $50/year. Normally you would pay down both the interest & principle, but compound interest works as if you let it build up over time. So if you left that loan for 5 years without paying a cent this is how the yearly balance would go:

Notice that if you simply added up the five years of fixed $50 interest payments ($250) that it’s less than the $276.29 at the end of year five (compound). That’s because after each successive year, the interest payment is added to the principal and then the 5% applied. If you’re responsible for the loan, it doesn’t sound like a very good deal for you right? But what if you were an investor & stood to gain $26.29?That’s the importance of how compound interest works: over time it slowly adds the financial gain you make on an investment and builds it into a curved line which is always slightly ahead of fixed interest (straight line).So let’s take a nursing example: have you ever wondered why you start to feel sick a few days before you get the full brunt of the cold? You can now blame that on compound interest.Say you catch a bacteria or virus from someone at work, home or anywhere else. After one hour that single cell divides into two, after two hours it divides into four, three hours into eight, four hours into sixteen and soon you have hundreds of thousands of cells in your body making you feel like crap only 24-36 hrs after first feeling sick. In science we call this “exponential growth”, but what it really is can be termed compound interest.
The importance is to realize that the sooner you can double your investment return, the faster your accent on the exponential curve.

So the “Rule of 72” is a simple answer to the question of “how soon will my investment double?” If you take your rate of return (5%, 10%, 15%) and divide 72 by that number, you’ll get the number of years it will take for you to double your investment if that return remains the same.

It’s important to understand this is a guide used to help you anticipate and understand the influences of growth on your investments. What you shouldn’t be doing is saying, “I need to return 15% because I want to double my investment every five years.” That goal is likely too aggressive and the amount of risk too high to successfully attain. But what this will do is put into perspective the influence that compound interest will have if your returns are consistently near the same level over a period of years.
So the question to really ask yourself is…

Where would you like your portfolio to be on this curve?

{ 7 comments… add one }
  • Average Joe July 4, 2007, 11:55 am

    I think this article really puts the effects of fees in perspective.

    Great article.
    Average Joe

  • Average Joe July 4, 2007, 11:57 am

    Oops. I meant to post the above comment for the article comparing the AGF portfolio vs TD.

    Although this article is interesting too. 🙂

  • Nurse B, 911 July 4, 2007, 1:06 pm

    Thanks for the feedback Joe. Never been on your site before, but good quality & something I’ll definitely check out on a more consistent basis.

  • moneygardener (AKA investor99) July 4, 2007, 5:49 pm

    The miracle of compound interest always reminds me how much ‘Dividends Matter’.

  • Nurse B, 911 July 4, 2007, 7:36 pm

    Even more so when you include “GROWING” Dividends 🙂

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