Sooner or later you’re going to hear about the “Rule of 72” if you talk about investing long enough. The “Rule of 72” is a simple formula that helps you figure out how quickly your money doubles based on the interest rate you earn. Sounds harmless…right? Well it’s not. First let’s look at how it works and then I’ll suggest why it can be a dangerous tool in the hands of investors leading to unsafe financial moves.
How It Works
Let’s say you buy a bond and are fortunate enough to earn 5% tax-free. Using the “Rule of 72” we take 72 and divide it by 5. The result is 14.4. That means it takes 14.4 years to double your money if you invest your money at 5% (and reinvest the income). If you invest your money at 10%, guess how long it takes to double? If you said 7.2 years – we have a Bingo! You are right.
Now that you know what the rule of 72 is, you should forget about it. There are 4 reasons why I implore you to do so.
4. The “Rule” Ignores Risk
The” Rule of 72” looks at return without considering risk. Think about the two examples I used above. Since the 10% investment doubles twice as fast as the 5% investment, an investor might conclude that the 10% investment is better.
But that ain’t necessarily so. To earn 10% you might have to take on more than twice the risk of a 5% investment and that riskier investment might not be appropriate for you. You won’t realize that if you only consider this silly rule.
3. You Can’t Control Or Predict All Returns
There are very few investors that offer predictable returns. Bank CDs are one option and bonds might sometimes be another. But that’s it. Once you venture beyond these alternatives it becomes difficult to predict how well your investment is going to do.
Over the last 100 years the stock market has returned 9.4% per year on average. But the 10 year returns are all over the map. There is simply no reasonable way to predict how well your stock market investments will do over the next 10 years. That being the case, what good is the “Rule” to you?
2. Lots of Bad Assumptions
People who refer to the “Rule of 72” assume that taxes don’t exist and that all dividends are reinvested but neither of these assumptions is always true. And if you do have to pay taxes on your returns (which most of the time you will) and/ or you withdraw the dividends or interest, you money won’t double as quickly as you expect.
1. Wrong Focus
The number one reason why the rule of 72 is dangerous to your financial well-being is because it distracts you. The main purpose of investing is to have more life – not more money. True, you may need more money in order to have more life but that isn’t always the case. I know that sounds weird coming from a professional financial advisor but it’s just the truth. I’ve met plenty of people who had all the money they needed. They just had to shift some of their financial behavior in order to be truly satisfied. Not everyone needs more money. Some people just need more understanding. Others need more focus and clarity.
This “Rule of 72” keeps investors thinking about time and money. Those are important of course. But not nearly as important as:
- Do you have enough income?
- Can you rearrange your assets to squeeze more income out without taking big chances?
- Is your portfolio appropriate for your situation today and will it be 10 years from now?
- Will you have enough money to last?
These are all the important questions that investors need to be asking themselves – and finding answers to. The “Rule of 72” tells you how quickly your money will double. So what? What are you going to do with that information?