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May 12, 2011

The Rule of Seventy-Two and You

Hey guys, how’s it goin’?

When a person is just starting out with investing, they may be wondering if the risk is worth it.  After all, they can get a high-interest (relatively) bank account at some online bank like ING Direct or a CD at their bank.  Sure, their money may not make the same returns, but it’s a lot safer.  If they have no risk tolerance, they will want to put their money in the most risk-averse vehicles and call it a life.  Of course, as the saying goes, “No guts, no glory.”

For the sake of argument, let’s look at the difference between the returns on no-risk instruments and more traditional, risky investments.  Let’s start by taking a look at something called the Rule of 72.  The Rule of 72 is a way to approximate how many years it will take to double your money.  It’s a simple formula:  72/(rate*100).

Let’s take a look at just how much you’re missing by staying in a low interest vehicle.

  • Scenario 1:  My portfolio is making an annualized return of 10.43%.  Using the Rule of 72, it will take 6.9 years to double my money. 72/(0.1043*100) = ~6.9
  • Scenario 2: I take my current portfolio and invest it into a 1 year cd at a rate of 3.25%.  Using the Rule of 72, it will take 22 years to double my money.  72/(0.325*100) = ~22
  • Scenario 3:  I take my current portfolio and put it into an ING Direct savings account at a rate of 1%.  Using the rule of 72, it will take 72 years to double my money.  72/(.01*100)  = ~72.

While I would like to live forever, I obviously won’t.  At 72 years, the best I can hope for is to leave my money to someone else to enjoy.  Even at 22 years, that leaves me with little time to enjoy the fruits of my labor.  While I may not be able to live high on the hog in twenty years with a 6.9 year doubling period, that’s still a pretty good chunk of change to help pay for things when I’m old.

If you want to be even marginally financially independent, saving is not enough.  You still need to save a significant amount every year, but you also need to find ways to make that money work for you and maximize returns.  For most people, that means investing.

If you found this post useful or know someone who can benefit from it, go ahead and pass it on.  Follow me on twitter, fan me on Facebook, sign up for the RSS feed.  Thanks.

Until next time, keep on saving!

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