Have you ever heard of the Rule of 72? It is not something that is common knowledge, even back in the 1980s, when Malaysian banks adopted its use to calculate payment schedules in the absence of computers. The formula fell out of use as computers became more widespread, making calculations much easier.
While it is not the most essential piece of information, knowing what the Rule of 72 is and how it works can go a long way in helping people better understand their finances and make better investing decisions.
What is the Rule of 72
To put it simply, the Rule of 72 is a quick, useful formula that is primarily used to estimate the number of years required to double the invested money at a given annual rate of return. It can also be used to compute the annual rate of compounded return from an investment, given how many years it will take to double the investment.
Basically, you would want to use it if you want to know within how many years your investment will double at a specific interest rate. Let’s say that you had RM10,000 that you would like to invest. The Rule of 72 will help you estimate the amount of time it will take for you to hit RM20,000.
The rise of computers and calculators have generally made this calculation rather trivial, but knowing the Rule of 72 comes in handy for mental calculations to quickly gauge an approximate value. As such, it is still commonly known among investors.
Calculating the Rule of 72
What makes the Rule of 72 so great is how simple it is. The basic formula is as follows:
n = 72 / i
The “n” represents the number of years it will take to double your investment, while the “i” would be the annual interest rate.
So lets say that you wish to invest RM10,000 into a specific investment vehicle that promises an interest rate of 6% per year. If you want to know how long it will take to double your investment to RM20,000, simply put the interest rate into the formula and solve the formula using any calculator.
n = 72 / 6
= 12 years
This means that it will take approximately 12 years for your RM10,000 investment to double to RM20,000 at 6% interest rate.
The formula itself is rather flexible as you can use it to calculate other things, such as the interest rate required, given the years it takes to double your investment.
How accurate is the Rule of 72
Simply speaking, the Rule of 72 is reasonably accurate. However, it does have its limits.
As mentioned above, the Rule of 72 is an estimate. It provides you with a good timeline, but still remains a prediction. It is only a simplification of a more complex equation. If you want to get the exact doubling time, you’d need to do a much more in-depth calculation. For those who are interested, the more accurate calculation is as follows:
n = ln(2) / ln (1 + (i / 100))
“ln” represents natural logarithm, which is a little too complicated to explain here. So just trust us and go with it. In order to save you some headache, simply utilise a calculator on your mobile phone to solve the formula.
If we use the previous example from above, the solution is as follows:
n = ln(2) / ln (1 + (6 / 100))
n = 11.896 years
As you can see, the solution represents a more accurate depiction of how long it will take to double your investment at 6% annual interest. However, the simplified version is still close enough.
The Rule of 72 is not the most essential piece of knowledge but it is something that every investor should be aware of. It allows them to have better guidance before committing to any investment or financial scheme. The only real drawback that this formula truly faces is that it tends to get less accurate the higher the interest rate presented.
So long as the interest lies between 6% to 10%, it should give a reasonably accurate estimate. Anything more than that, it would be better to go a little more in-depth with your calculations.
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