One of the more popular financial tricks in personal finance is referred to as the Rule of 72. Acting as a tool for quick estimations, the equation states that dividing the number 72 by the interest rate of an investment will show you how many years it takes to double your money in a given investment. As such, an investment into a savings account that pays 3% interest will double its principle amount in 24 years. Comparatively, an investment in a bond that pays 5% will double in 14.5 years. With that in mind, we can look at how it is that this rule can be taken a step further to evaluate our future wealth goals.
The first way to look at the ability of the rule of 72 to help us understand our ability to meet our long term financial goals is in terms of its applications in a portfolio. While we might have a bond that will double in 14.5 years, a portion of our money will still be in that savings account at 3% that will take 24 years to double.
If we have equal amounts of money in either of these products, we need to look at the average term values of these investments, and re-evaluate to determine how long it will take for the portfolio as a whole to double. We therefore need to divide each of these values by 2 (because they both make up half of our portfolio), and add them together.
The end result is that we will now double our portfolio value in approximately 19.25years. While this number provides us with a nice moderation between the liquidity of the savings account and the growth of the bond, it’s easy to see how it is that a saver can become frustrated by such a result. Realistically, this means that the saver will double their money 3 times in their lifetime at most. We therefore need to look at alternatives to building up the portfolio.
Another way for the rule of 72 to help us understand the nature of returns is by evaluating the effects of leverage. Specifically, how it is that leverage can improve our portfolio’s ability to obtain returns. Returning to our previous example, let’s assume that we are capable of obtaining secured debt at a rate of 3%, which we can then invest into the bond that pays 5%. The net effect is that we are obtaining a 2% return on the borrowed money, a 3% return on the savings account, and a 5% return on the bonds.
From there, we weight the portfolio as if we are investing in three separate assets, and come up with a portfolio return amount that is equivalent to 4.985%, assuming we only leverage the bond investment. This means that our portfolio will now again double in only slightly over 14.5years, even though we have only taken on incremental amounts of risk to the portfolio.