No, this isn’t an investment idea. It’s just a simple math hack!
When comparing investments we look at the rate of return expected on the asset. The easiest way for us to simplify the impact of returns is by calculating how long it takes to double our money.
An asset providing 10% returns will naturally take 10 years to double in case of simple interest. But most of the time we reinvest profits. This leads to compounding of our money.
If the same 10% rate of interest as the previous example is compounded, meaning interest accrued each year is invested back then it will take just 7.2 years to double your investment.
Compounding has its benefits and all that - but it’s so difficult to calculate it without a calculator, no? Well here’s a math hack for your compounding calculations.
What is the rule of 72?
It is an easy formula that estimates how long it takes to double your investment with a fixed rate of return while taking the power of compounding into consideration. It’s a very useful shortcut while comparing investments.
The simple calculation is 72 divided by the annual rate of interest (in percentage), which gives us the amount of time (in years) it takes to double an investment in value.
💡 Doubling time (number of years) = 72 / Annual rate of return (percentage)
Let’s say you want to compare a Fixed Deposit with 6% interest rate and a Bond with 8% interest rate, both of these are compounded annually.
Simply divide 72/6, which gives us 12. Thus it will take 12 years to double our money with this Fixed Deposit.
Similarly dividing 72/8 gives us 9. This means with the Bond our investment will double in value in 9 years.
With just some mental math and a nifty shortcut you are able to find out that it takes 3 years more to double your money with the given fixed deposit than the bond.
The importance of compounding
Compound interest is the principle by which the interest you earn also earns interest. Now the longer you earn interest, the more your interest is able to generate more interest, resulting in exponential growth of wealth.
Notice how much more you can make by holding investments that compound as opposed to those who don't.
Reinvesting the returns of a Rs. 1 lakh investment could earn you more than twice as much in 20 years; assuming a 10% rate.
The power of compounding
Where else can it be used?
The rule of 72 can be used anywhere compounding is involved - population, GDP growth, charges, or loans.
Here are some examples:
⚡ Inflation is the reduction in purchasing power of a given currency. If inflation is 6% for the rupee, then after 12 years 1 rupee will be worth just 50 paise in terms of purchasing power ( 72 / 6 = 12).
🐣 Consider a fictional country, Ambrosia, which today has a population of 500K growing at a rate of 2% per annum. Ergo at this pace in 36 years Ambrosia will have 1 million citizens (72 / 2 = 36).
💧 Mutual funds, usually charge annual expense fees on the principal invested. Let’s say ABC fund has an expense ratio of 2.5%, as a result 2.5% of the principal invested is deducted every year. Thus in 29 years, you would have paid in fees a total of half of your investment amount.
On that note, it’s important you choose investments that cost lesser, while not compromising on performance. Do check out our all-weather portfolios, which are a bunch of ETFs from 5 different asset classes put together. These have yielded between 12-17% CAGR (doubling in 4-6 years), for fees as low as 0.5%. Along with brokerage, management fees by the AUM and our advisory fees, the total damage would be as low as 1%.
Click here to know more: https://rupeeting.smallcase.com/