The Rule of 72: What is it and how does it work?

Many investors want a simple way to estimate how much their money will potentially grow over time. The Rule of 72 provides an easy solution, allowing anyone to calculate how long it takes to double an investment based on its fixed annual return.

This concept isn't limited to investments, though, as it can also offer insights on inflation, loan interest, and other areas of financial planning. While it's an approximation, the Rule of 72 remains useful for anyone who wants to understand the growth of financial assets under specific conditions.

What is the Rule of 72?

The Rule of 72, first introduced by mathematician Luca Pacioli in 1494, is a simplified formula used to estimate how long it takes for an investment to double in value under a fixed annual rate of return. It works by dividing the number 72 by the expected annual return, providing a quick and approximate doubling time.

The Rule of 72 formula is:

Doubling time (years) = 72 ÷ Expected annual rate of return (%)

Beyond investments, the Rule of 72 in finance applies to any scenario involving exponential growth or decay, such as inflation or debt accumulation. It highlights the power of compounding, making it a versatile tool for both beginner and advanced investors.

How does the Rule of 72 work?

The Rule of 72 in investing is built on the principle of compounding, where returns are calculated not just on the initial investment but also on the accumulated gains over time. It provides a quick estimate of either the time required to double an investment, or the annual rate of return needed to achieve that goal.

Let’s look at some Rule of 72 examples: an investment with an 8% annual return will double in approximately nine years (72 ÷ 8 = 9). Alternatively, to double your money in a specific time frame, divide 72 by the desired number of years. For instance, doubling your investment in 24 years would require an annual return of 3% (72 ÷ 24 = 3).

However, this method works most accurately for returns between 5% and 10%, where compounding behaves predictably. But it’s important to know that at extreme rates—either very high or low—the rule becomes less precise due to the non-linear nature of exponential growth.

The Rule of 72 also reveals financial risks. A loan with a 12% annual interest rate will double the amount owed in just six years, illustrating the impact of high borrowing costs. Similarly, inflation erodes purchasing power rapidly. For example, a 4% inflation rate halves the value of money in 18 years (72 ÷ 4 = 18).

Applications of the Rule of 72

To see how simple and practice this formula is, let’s take a look at the different applications of the Rule of 72 in more detail.

Estimating investment growth

As previously mentioned, the most common practice in Rule of 72 investing is providing an estimate of how long it takes for an investment to double in value. For instance, an investor earning a 6% annual return can anticipate their portfolio doubling in 12 years (72 ÷ 6 = 12). This quick calculation helps set realistic expectations for long-term financial planning without requiring complex computations.

Understanding inflation's impact

Inflation erodes the purchasing power of money over time, and the Rule of 72 estimates how quickly this happens. For instance, at a 3% inflation rate, the value of money will halve in 24 years (72 ÷ 3 = 24). Since inflation acts as a "negative compounding" force, this underscores the importance of investing in assets that consistently outpace inflation, such as equities or real estate, to maintain and grow wealth.

Assessing loan and credit costs

The Rule of 72 is also helpful in evaluating the impact of compounding interest on debt. A credit card debt with an 18% annual interest rate will double in just four years (72 ÷ 18 = 4). This stark illustration highlights the urgency of managing high-interest debt to avoid exponential growth in liabilities.

Evaluating fees and expenses

Investment fees reduce the effective annual return, which extends the time required for an investment to double. For instance, an 8% annual return with a 2% fee results in a net return of 6%. According to the Rule of 72, this increases the doubling time from 9 years (72 ÷ 8) to 12 years (72 ÷ 6). This highlights the importance of minimising costs to optimise long-term growth.

Advantages of using the Rule of 72

The Rule of 72 provides several advantages that make it a popular tool for financial planning. Here are the main ones:

Simplicity for quick calculations

One of the most significant advantages of the Rule of 72 is its ease of use. Without the need for advanced calculators or software, investors can estimate doubling times or required returns quickly. For example, determining that an investment with a 10% return will double in about 7.2 years (72 ÷ 10 = 7.2) can be done mentally. This makes it an accessible tool for quick decision-making.

Versatility across financial scenarios

The Rule of 72 applies to more than just investment growth. Its adaptability extends to understanding inflation, evaluating debt, and even gauging the effects of fees on mutual fund returns. Whether planning for retirement or managing high-interest credit card debt, this tool offers useful insights into the effects of compounding over time.

Practicality for financial literacy

The simplicity and applicability of the Rule of 72 make it a staple in financial education. It introduces the concept of exponential growth and compounding in an easy-to-understand way, encouraging better financial literacy.

Benchmarking tool for financial goals

The Rule of 72 helps investors evaluate financial goals by providing a clear benchmark for expected returns. For example, an investor with a portfolio earning an average annual return of 6% can anticipate doubling their money in 12 years (72 ÷ 6). If this timeline doesn't align with their goals, they might explore higher-return investments or increase contributions to meet their objectives.