"Double your money, fast!" Do those words sound like the tagline of a get-rich-quick scam? If you want to analyze offers like these or establish investment goals for your portfolio, there's a quick-and-dirty method that will show you how long it will really take you to double your money. It's called the rule of 72, and it can be applied to any type of investment. (For more ideas on how you can double your money, check out 5 Ways To Double Your Investment.)
TUTORIAL: Investing 101
How the Rule Works
To use the rule of 72, divide the number 72 by an investment's expected annual return. The result is the number of years it will take, roughly, to double your money. For example, if the expected annual return of about 2.35% (the current rate on Ally Bank's 5-year high-yield CD) and you have $1,000 to invest, it will take 72/2.35 = 30.64 years for you to accumulate $2,000.
Depressing, right? CDs are great for safety and liquidity, but let's look at a more uplifting example: stocks. It's impossible to actually know in advance what will happen to stock prices. We know that past performance does not guarantee future returns. But by examining historical data, we can make an educated guess. According to Standard and Poor's, the average annualized return of the S&P 500 from 1926 to 2010 was 12.01%. At 12%, you could double your initial investment every six years (72 divided by 12). In a less-risky investment such as bonds, which Standard and Poor's says have averaged about 6% over the same time period, you could expect to double your money in about 12 years (72 divided by 6).
Keep in mind that we're talking about annualized returns, or long-term averages. In any given year, stocks will probably not return 12% - they might return 25% or lose 30%. It's over a long period of time that the returns will average out to 12%. The rule of 72 doesn't mean that you'll definitely be able to take your money out of the stock market in six years. You might have actually doubled your money by then, but the market could be down and you might have to leave your money in for several more years until things turn around. If you must achieve a certain goal and be able to withdraw your money by a certain time, you'll have to plan carefully, choose your investments wisely and keep an eye on your portfolio. (To help you invest in the long term, see 10 Tips For The Successful Long-Term Investor.)
Achieving Your Investing Goals
A professional financial advisor may be your best bet for achieving specific investing goals, but the rule of 72 can help you get started. If you know that you need to have a certain amount of money by a certain date (say, for retirement or to pay for your kid's college tuition), the rule of 72 can give you a general idea of which asset classes you'll need to invest in to achieve your goal.
Let's say you have a newborn baby girl. Congratulations! You now have 18 years to come up with enough money for her college tuition. How much will you need?
First of all, you can use the rule of 72 to determine how much college might cost in 18 years if tuition increases by, let's say, 4% per year. Divide 72 by 4% and you know that college costs are going to double every 18 years. You have high hopes that little Madison will attend Harvard. Harvard's undergraduate tuition and fees for the 2011–2012 academic year are $52,650. For the last two years, Harvard has increased tuition and fees by 3.8% per year. This means tuition and fees, if Madison were entering college today, would likely cost $52,650 for freshman year, $54,650 for sophomore year, $56,727 for junior year, and $58,883 for senior year. Total bill: $222,910. Double that, since you calculated that the cost of college will double in 18 years, and you get $445,820.
Right now you have $1,000 to invest and with an 18-year time horizon, you want to put it all in stocks. We saw in the previous section that investing in the S&P 500 has historically allowed investors to double their money about every six years. Your initial $1,000 investment will grow to $2,000 by year 6, $4,000 by year 12, and $8,000 by year 18. Clearly you'll have to find a way to finagle contributions from the grandparents or let little Madison know that she's on her own when it comes to paying for college. Eighteen years isn't as long of a time horizon as you thought!
How much would you have to invest today to get $450,000 in 18 years at 12% per year? To figure this out, just work backwards, halving your money every six years. You'd need to have $225,000 by year 12, $112,500 by year 6, and $56,250 by … yesterday. (For help in achieving your investment goals, check out 4 Steps To Building A Profitable Portfolio.)
Shortcomings of the Rule Of 72
The rule of 72 isn't perfect. First of all, it does not take into account the effect of investment fees, such as management fees and trading commissions, on your returns. Nor does it account for the losses you'll incur from any taxes you have to pay on your investment gains.
Second, it's a rough guideline. To get a more precise outcome, you'll need to understand algebra and use the future value formula. But if you don't mind having your calculations be off by somewhere between a few months and a year, the rule of 72 will fill your needs. (To determine the best strategy for you to achieve the returns your need for the future, read Long-Term Investing: Hot Or Not?)