The
“Rule of 72”
How
to Quickly Estimate
Whether
You Will Run Out of Money
Before You Die
by
Einstein is reputed to have said, “The most powerful
force in the universe is that of compound interest.” I choose not to argue the
veracity of the quote, but rather use it as a springboard to discuss a most
important finance principle.
Better known as the Rule of 72, the power of compounding
allows us to determine how long it will take a sum of money, invested at a
certain interest rate, to double in size.
The history behind this principal dates to early
references in the SUMMA DE ARITHMETICA written by Luca Pacioli in 1494. He
postulated that if you divide interest into 72, the result is the number of
years it will take for the principal sum to double.1
This rule can also be used to estimate the interest rate
involved in the change in value of an investment.
Here are a couple of examples. Let’s say I am planning my
retirement and am concerned about inflation. How long before my cost of living
is twice what it is today? If I assume an inflation of 3% then 72 divided by 3
equals 24 … or at 3% my cost of living will double in 24 years or 36 years at 2
percent!
Forty years ago, a U.S.
In 1971 gasoline was $.40 a gallon according to Dept. of
Commerce figures. If a gallon of gas is selling for $3.20 today, again, using
the Rule of 72, we can estimate the inflation by counting the number of times
it has doubled, three times to be exact. Divide 40 years by 3 = 13.33, and then
divide 72 by 13.33 = 5.6%)
Let’s say your daughter or granddaughter is 18. What has
happened to the Dow Jones® Industrial Average during those 18 years?
Using prices at that time, you can determine the Dow had increased 6.52%,
compounded annually. This implies a doubling every 11+ years.
According to data from “ANNUITY 2000 MORTALITY TABLE: SOCIETY OF ACTUARIES”2 a male age 65 has a 50% chance of living to age 92, females to age 94 or a couple age 65 has a 50% chance of one being alive at age 97!
Statistically, we can assume that one half of this
population will live shorter and one half will live longer than those figures.
Given the natural inclination of Baby Boomers to want to live forever, we can
see why it is important that investments be plentiful and growth bountiful in
order to ensure that Baby Boomers do not outlive their money.
Applying our understanding of compounding, at a 3%
inflation rate, our cost of living will be double 24 years from now. But, by
keeping a long term investment horizon and using the Dow Jones Industrial Average
for a proxy, our investments would be adequate to keep pace with inflation,
assuming the 6.52% of the past 18 years holds true for the next 18. Naturally,
past performance does not guarantee anything at all about the future.
There are two key things to remember from the above
discussion: first, inflation has and will continue at some rate for the rest of
our lives, and second, to ensure that we will not outlive our money, we need to
have something in our portfolio that, over time, will out grow inflation!
References:
2
Society of
Actuaries – www.soa.org
