What is the Rule of 72?
Notes from the video ‘Diffusion Academy| Finance |Rule of 72?‘ :
What is Rule of 72?
The rule of 72 is a great mental math shortcut for estimating how long it will take compounding interest to double an investment.
To estimate the number of years required to double your money:
You have to divide 72 by the compound annual interest rate.
For example, if we want to find out how long it will take for an investor who invests $100,000 at 5% annual interest rate to double his money. We can use the rule of 72.
When we substitute these values into the formula, we get an estimation of around 14.4 years.
We can also use the rule of 72 to find out how long it will take for money to lose half its value because of inflation.
For example, when inflation rate goes up from 2% to 3%, your money will lose half its value in 24 years instead of 36.
The rule of 72 shows why a seemingly small difference in inflation or GDP expansion has such a huge effect in forecasting models.
The Rule of 72 can also be used in areas other than finance.
An example would be to calculate how many years it will take for the population to double.
A country with population growth rate of 3% will double in population in 24 years. If the population growth rate was at 5% instead, the population will double in 14 years!
That’s 10 years difference with just 2 percentage points!
The Rule of 72 shows how a seemingly small change in the growth rate could be a huge problem for planning.
Although the rule of 72 is useful as a quick, mental calculation to estimate how long it will take for an investment to double, it is important to note that the rule of 72 is just an approximation and not exact.
For example, in the first example, we stated that the investor will double his money in 14.4 years at a 5% annual interest rate.
This figure is only an estimation and the actual number of years it takes for the investor to double his money at 5% annual interest rate is 14.21 years.