How the Rule of 72 Spots the Too-Good-To-Be-True Deals

einstein-compound-interest-rule-of-721.jpgYou may have heard the saying ‘If it sounds too good to be true, it probably isn’t true’. But how do you work out what could be too good to be true?

Start with the rate of return you have been offered. Most investments illustrate their rates of return using percentages. While that’s perfectly reasonable, research suggests that many people have trouble working out percentages, especially in their heads.

To determine how many years for your capital to double, you bring to mind the Rule of 72, which tells you to always divide the capital by the interest, and the result is in how many years it will be doubled. This is simpler than it seems. Before calculators or spreadsheets, investors used the trusty old ‘Rule of 72’.

How the Rule of 72 works

Suppose you were offered an investment with a return of 10% per year and you reinvested all your returns. How many years would it take to double the value of your original investment?

Read

The Rule of 72 tells you: divide 72 by the annual rate of return to get the number of years it will take to double your money.

So for 10% return per year: 72 divided by 10 = 7.2 years for your original investment to double.

If you get a 20% per year return, it will take a shade over 3½ years to double your money (72 divided by 20 = 3.6 years). Similarly, if you get only 3% per year you will have to wait 24 years (72 divided by 3 = 24 years).

The Rule of 72 is not absolutely precise, but it gives you a practical estimate that you can work out in your head. By using the Rule of 72, you can find out if an investment return really is ‘too good to be true’, and avoid being taken in by scams.

The Rule of 72 also forecasts the value of money

In finance, the Rule of 72 is a method for estimating an investment’s doubling time or halving time. These rules apply to exponential growth and decay respectively, and are therefore used for compound interest as opposed to simple interest calculations.

To determine the time it takes for the value of money to halve at a given rate, divide the rule quantity by that rate.

To determine the time for money’s buying power to halve, financiers simply divide the “rule-quantity” by the inflation rate. Thus at 3.5% inflation using the rule of 72, it should take approximately 72/3.5 = 20.571 years for the value of a dollar to halve.

You may also like...

8 Responses

  1. Robinsun says:

    Hello Robin,

    You got a nice blog.
    What do you do actually?

  2. Robin Bal says:

    Hi Robinsun,

    Welcome to FortuneWatch and thanks for your kind words. I am a Financial Advisor.

    Take care and cheers.

  3. Toby says:

    Why is it 72? I thought it was 70!

    It’s part of the exponential function and I was taught that it was 70 (formed from the approximate division of 100 by the natural logarithm of 2).

    Can you clarify this?

  4. Robin Bal says:

    Hi Toby,

    Thanks for your comment. In Finance there have been rules of 71 and 69.3 also. The Rule Of 70 is normally explained only in terms of positive growth rates.

    Rule Of 72 is used in a similar fashion, except that you divide the rate into 72 rather than 70. Rather than obtaining a population doubling period, you would typically calculate an investment doubling period. In finance, the Rule Of 72 is probably used in preference to the Rule Of 70 as 72 has more whole number divisors.

    Hope this answers your question.

    Take care and cheers.

  5. Who’s the genius that come out with “Rule of 72”?

  6. Robin Bal says:

    Hi Viv,

    How you doing? Well that genius behind Rule of 72 was definitely not me…lol. The genius is none other than the guy in the picture, Albert Einstein.

    Take care and cheers.

  7. Socrates says:

    ah, no.

    the “rule of 69” (more cachet, i think) has been known since about 6 microseconds after the logarithm was invented, which is to say, at least since 1614.

    what does the rule have to do with the title of your article? an audience that has calculators would be a lot better served with some advice on how to identify “too good to be true”.

  8. Kat says:

    I wonder why my finance instructors never told us about this secret! Fantastic.

    Thanks!

Leave a Reply

Your email address will not be published. Required fields are marked *

debt relief
http://debt-settlement-review.toptenreviews.com/national-debt-relief-review.html>