Investing and the 'rule of 72'

As an investor, the dream is to grow the money invested over years. Investors specifically look for opportunities that double their money or even earn more than double.

But usually investors are told the annual rate of return that they can earn on their investment. No broker, no investment advisor ever tells them how many years will it take for them to double their money from a specific investment.

However, there is a simple tool by which you can calculate when this event would take place. If you know the rate of return that you can earn from an investment, you can easily find out how long would it take to double your money.

This tool is called the 'rule of 72'. Very simply, this rule states that:
Number of years to double your money = 72 divided by Rate of return

So if an investment earns a return of 10% per annum, the number of years in which your money would double in it will be 7.2 years (72/10).

This is the 'rule of 72' that you need to understand when you make your investments. Obviously this rule would only favor those who are invested for a longer period of time. The reason for this is that only risk free investments like fixed deposits and bonds can give steady rate of returns year after year. Since these investment options are less risky, the rate of return from them will be lower too.

If we look at stock markets, the returns are much higher. However, so are the risks. No one can predict the exact return that the investment in stocks can give each year. While an investor may earn 30% or more in a good year, in a bad year the same investor may end up losing over 50%. Thus the annual returns are not predictable.

So, does this mean that the 'rule of 72' cannot be applied to stock markets?

No, it can be applied! The idea is not to try and take one year's gain as the rate of return that the stocks can give us each year. Obviously this is not possible. Instead, it would be better to use a longer period of time like 4-5 years to get a more probable rate of return.

For instance, if a stock has generated an average annual return of 20% over the previous 5 years, then you can use this 20% return as a basis to find put when your money would double if you were to invest in this stock. Using Rule 72, it would be 72/20 or 3.6 years. However, you would have to remember that this 20% is not guaranteed. Therefore, 3.6 years is just a rough approximation of the time period. Also, the P/E of the stock also comes into the picture here. It helps if the P/E is not way out of line with respect to historical trends and is expected to remain stable over the next few years. It is only in such cases that the rule of 72 is likely to take us as close to the right answer as possible.

Clearly then, while this rule does help us understand our investment period better, we must remember to apply it carefully. For the correct application of the rule, the rate of return has to be calculated with utmost care. Being over-optimistic or over-pessimistic will just result in losses.