The Compounding Rule of 72…
If anyone asks me for advice in investing (it’s happened 2 and half times. One time, I misunderstood the question), I tell them how Albert Einstein called Compound Interest the 8th wonder of the world. Granted, he was a theoretical physicist, not a financial advisor, but I’m sure if he wanted to give us advice on how to bake Bundt cakes or how to throw a slider we’d listen.
The Rule of 72 is my favorite way to explain this concept:
You take 72 divided by a rate or return and it will tell you how long it would take that money to double (or for the purchasing power to cut in half, in the case of using inflation rates).
I’ll use 7.2% for my example because the math is easy. That means our investment will double every 10 years. When explaining this to people in real life, I’ll draw out on a cocktail napkin a chart showing the ages of an investor: 25, 35, 45, 55, and 65 across the bottom.
I ask them to pick a number to invest at age 25. $2,000? Okay, let’s plot that here at age 25. At age 35, that will double to $4k… then $8k, and so on until we get to $32k. I’ll connect the dots, which reveals a steady incline with a VERY steep curve at the end.
For effect, I’ll even purposefully make a “mistake” which requires a second napkin to be able to fit the return in the last ten year period, so it’ll look like this:
“Pick any 10 year period on this napkin… ” I’ll say. “Which 10 years do you like the return on investment the most?” Everyone (both people) points to the last 10 years leading up to age 65.
The lesson is obvious…start earlier and earn great returns later. Keeping $2,000 today foregoes $16,000 later. Imagine what the curve looks like when you add $2,000 EVERY year? Now figure this with 15% saved instead of just $2,000? The numbers start to get impressive.
This blog was originally posted on Budgets Are Sexy.