Tag Archives: Compound Interest

The Rule of 72

Do you want to know how long it will take to double your money?  Most investors do.  Are you interested in the expediential growth of your money?  Have you ever tried to calculate the rule of 72?

When I first started to read personal finance and investing books, I learned about the math behind what makes investing work.  The big driver behind what causes your money to grow is compound interest. While I was studying, the one theory that I kept coming across was the rule of 72.

The rule of 72 is just a basic mathematical formula.  It is used as a tool to help investors determine when they should expect to double the money they currently have invested.  The rule of 72 allows an investor to know when they should expect to double their money based on a forecasted rate of return.

Start by taking the projected rate that you expect your investment to return every year.  Divide that interest rate by 72. That will give you the number of years that it will take for you to double your money.

Example:

72 / 6% expected rate of return = 12 years to double your principal

72 / 8% expected rate of return = 9 years to double your principal

72 / 10% expected rate of return = 7.2 years to double your principal

The rule of 72 is what makes stocks a more attractive option than bonds or other fixed-income investments.  For example, the Vanguard 500 (VFINX) has returned 10.97% per year between the years 1976 and 2016.  Currently, the average interest rate on an FDIC insured savings account is slightly higher than1.15%. What is the difference between these two investments based on the rule of 72:

Vanguard 500 – 72 / 10.97 = 6.56 years to double your principal

Saving account (national average) – 72 / 1.15 = 62 years to double your principal

Over the coming decade, stocks are not expected to return 10% per year.  Currently, stocks are expensive investments and there is not much value to be found.  Jack Bogle who founded Vanguard and the first S&P 500 index fund that was available to individual investors predicts a more modest return of 6 or 7 percent for the coming decade.  Based on that forecast and the rule of 72, how long would it take to double an investment of $3K in the Vanguard S&P 500 fund:

Vanguard 500 – 72 / 6.5% = 11 years to double your principal

Time is on Your Side

When I started investing, I received a brochure from the investment company that provided me with a few charts on compound interest.  The chart showed how the rule of 72 worked with different interest rates. The brochure explained the wealth-building power of stocks vs more conservative investments based on the difference in long-term performance.  It also showed how it benefited an investor who had a few decades to take advantage of this powerful wealth building formula.

For example, a one-time investment of $10K to grow in value to $40K based on different interest rates:

  • If an investor received a return of 3%, it would take 48 years for that $10K to grow to $40K
  • If an investor received a return of 6%, the time would be reduced to 24 years to grow to $40K
  • If an investor received 12%, however, it would only take 12 years to grow $10K to $40K

What to do Now

What can investors do now to follow the rule of 72?  What are some alternatives since the S&P 500 is projected to underperform its historical average?  Is it possible to try to reduce the time it takes to double your money without taking on too much risk?  Here are some options that might help in doubling your money quicker:

Save more money.  By increasing your savings, you will double your money at a faster pace.  Try to increase your savings by 2-3% per year.

Go beyond the S&P 500.  Add a small-cap blend or extended market index fund that includes mid-cap stocks to your asset allocation.  Small-cap stocks have historically outperformed large-cap stocks. If you go with a 4:1 Ratio, you will emulate the total stock market.

Go beyond the United States for investing opportunities.  Add some international stocks to your portfolio. Add both developed nations and emerging markets for their growth potential.

Remember to keep some bonds in your portfolio.  Many experts are telling investors to stay away from bonds because of their current low yield and the raising interest rates.  Bonds have an opposite correlation than stocks. When stocks go down in value, bonds go up. By owning some bonds, you can buy stocks at a lower price when there is a stock market correction.

Conclusion  

As an investor, you should keep the rule of 72 in the front of your mind.  You do not need to know the exact date as to when you will double your money.  From time-to-time, look at how your portfolio performed over the past 5 or 10 years to identify what your average rate of return is.  Apply the rule of 72 to know where you stand. If you are not satisfied with how long it is taking, look for ways to increase your returns that are within your risk tolerance.   

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Saving: The Foundation for Financial Success

Is your goal to reach financial independence?  Do you want to retire early?  If you have an ambitious financial goal, there are many things that you must do correctly.  For example, you need to always be working on improving your ability to earn more money.  You must live below your means.  You must invest wisely in stocks and bonds.  It is also important to take advantage of tax-deferred accounts like a 401K or IRA.  Yes, all those steps are important, but in my experience, having a high savings rate is the most important step to becoming financially successful.

I see savings as the foundation for being financially successful.  Without savings, there is no money to invest.  It is the foundation for one’s financial house to be built upon.  For a house to last, it needs a solid foundation.  If you skimp on the sand or mortar, the foundation will not be suitable to support the structure that you are dreaming about constructing.  If you are not saving enough money, you will not have enough to support a high quality of life when you retire and draw from your savings to pay your expenses.

Savings Rate

This will probably not come as a big surprise, but American’s are not saving enough.  The current national savings rate is just over 5%.  As recent as the 1980’s, the saving rate in the United States was over 10%.  If your goal is reaching financial independence and ultimately early retirement, a savings rate of 5% is not enough.  Even with compound interest, it would simply take too long to grow into a substantial enough nest egg to cover your living expenses.

How Much is Enough

In the classic personal finance book The Richest Man in Babylon, a savings rate of 10% is suggested.  I feel 10% is the bare minimum that the average American should be saving.  I do not think that is nearly enough if your goal is early retirement.  It might be suitable if your goal is to reach financial independence by age 65, but not if you want to retire at age 50.

If you are just entering the workforce, start by saving 15% of your salary.  Work on increasing that rate every year.  Try to increase it by at least 1% annually.  Increase it with every annual raise or bonus.

Spending

Spending is the opposite of savings.  Spending is the enemy of wealth creation.  Spending leads to lifestyle creep.  The more stuff you buy, the more stuff you will want.  There is always something new or better than what you own.

Marketers earn a living by trying to convince you to buy what they are selling.  When you see that your friends or neighbors have the newest products, you will want to upgrade your stuff too.  This is a vicious cycle without an end.

The secret to winning this game is to not play.  Every dollar that you spend puts you one dollar further away from financial independence.  On the other hand, every dollar you save goes towards buying your freedom.

Debt

Debt is created when you spend more than you earn.  Some debt is not as bad as other debt.  Student loans provide you with the funds to get an education to obtain the skills to earn a higher salary.  Taking out a mortgage enables most Americans to be homeowners.  You still must use extreme caution before you incur any type of debt.

Bad debt comes in the form of credit cards, auto loans, and payday loans.  All debt, however, prevents you from saving as much as you could be saving.  When you take on excessive debt, you become a slave to your creditor.  It is possible, but difficult to escape from the bondage of debt once you start to slide down that slippery slope.

Why Save So Much

Once you take on the mindset of a saver, you will never be a spender.  Personal Capital is a free online platform that is great for tracking savings.  That feeling of accomplishment of watching your savings grow is far greater than any new product that you can buy.

After you become a saver, you might notice a mental twist occur.  Once you reach a point in life when you could afford luxury cars and upgrade to a larger house, you will realize that you do not want to waste your money on any of that stuff.  Buying new stuff will become unimportant.  You will see it as being wasteful.

At that point, spending is viewed as an opportunity cost.  You will want your money to keep growing.  Financial independence will become the most import thing that your money can buy.  There is no product or service that is more appealing than having mastery over your own life.

As a saver, you will always be trying to optimize your spending and to live on less.  It is fun to try to stretch a dollar as far as it can be stretched. This mindset will greatly help you on your journey toward financial independence because you will need less money to live on.

For example, if you can live on $40,000 per year, you only need to have $1,000,000 saved based on a 4% withdrawal rate.  What about if you want to live on $100,000 per year?  You would have to have $2,500,000 in savings at a 4% withdrawal rate.  The more money you require, the further away you are from freedom.

Compound Interest

Compound interest works no matter what your saving rate is.  It is just math.  It just works better if you have a high savings rate.  For example, Joe saves $800 per month and Bill saves $2,000 per month.  Their savings both grew by 8%.

How much will Joe have in savings after ten years?  He will have over $147,000 saved.  That is a nice sized nest egg.  It is a solid foundation to build upon.  However, he is still a long way from financial independence.

How much will Bill have saved?  Bill will have over $368,000 in savings.  Bill is well on his way to reaching financial independence.  He is starting to see the light at the end of the tunnel.

As you can see, compound interest worked out well for both Joe and Bill.  Joe has a nice financial foundation.  Bill, on the other hand, has almost 10 years of living expenses stashed away assuming he can live on $40,000 per year.

Conclusion

Start saving early.  Save as much as you can.  Always try to save more.  Don’t be fooled into thinking that you are missing out on anything because you are saving too much.  Once you become a saver, you will have established the required foundation that is needed to fuel the wealth building process.

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