What is the Rule of 72, and why does it matter?

Understanding how your money grows over time is crucial to investing and personal finance. The Rule of 72 is one of the most straightforward and useful tools for gauging the power of compound interest.

This simple formula can help you estimate how long it will take for an investment to double in value, providing a quick snapshot of the potential impact of your financial decisions.

But what exactly is the Rule of 72, and why does it matter? Let's dive in.

What is the Rule of 72?

The Rule of 72 is a quick, mental math formula that estimates the number of years required to double an investment at a fixed annual rate of return. The formula is:

Number of Years to Double = 72 / Annual Rate of Return

For example, if you have an investment expected to grow at an annual rate of 6%, the Rule of 72 tells you that your money will take approximately 12 years (72 ÷ 6 = 12) to double.

The beauty of the Rule of 72 lies in its simplicity. Without needing a calculator, you can quickly assess the impact of different rates of return on your investments.

Let's take an example. Core Logic revealed Sydney house prices doubled in the past ten years, cited by the Australian Financial Review in January 2024. Using the Rule of 72, we can determine a compound annual growth rate (CAGR) of approximately 7%.

How can we apply this to investment decisions?

This is useful when comparing different investment opportunities.

Now, let's deepen our analysis by considering another key principle: over the long term, share prices tend to align with the companies' earnings growth rates.

By combining these two 'rules,' we can roughly estimate the growth potential of certain investments. For this exercise, I'll use examples from the top ASX shares whose values increased tenfold over the past decade, which my colleague Bernd highlighted.

The first example is Pro Medicus Ltd (ASX: PME). The medical diagnostics software provider's earnings per share (EPS) increased from 1.5 cents in FY14 to 79.1 cents in FY24, implying a CAGR of 49%. Its share price gained 13,170% or roughly 65% annually during this period.

More recently, the company's EPS grew at around 30% per year over the last three years.

Similarly, the second example is Pinnacle Investment Management Group Ltd (ASX: PNI) shares, which have gained 1,930% over the past decade, translating into a CAGR of approximately 34%.

During this period, its EPS went from 3.4 cents in FY14 to 45.5 cents in FY24, at a CAGR of 30%.

From these two examples, investors might assume the following:

• If the company can maintain the 30% annual profit growth, the invested money in these shares could double in 2.4 years.
• If the earnings growth decelerates to 20% per year, the invested money would double in 3.6 years.

This is a simplified exercise, assuming the market valuations, such as the price-to-earnings ratios, remain constant. But this is a helpful way to get a quick-and-rough estimation.

Other implications

Investors often have unrealistic expectations about how quickly their money can grow. Using the Rule of 72, you can set more realistic goals and better understand the time horizon required to achieve them.

For instance, expecting your money to double in five years would require a return of about 14.4% annually (72 ÷ 5 = 14.4%), which is quite high and not typically sustainable in most traditional investments.

Whether deciding between a high-risk, high-reward investment or a more conservative approach, the Rule of 72 can help you weigh your options.

If you're considering a stock that promises a 9% return versus a bond offering a 4% return, the Rule of 72 shows that the stock could double your investment in eight years, while the bond would take 18 years.

Foolish takeaways

The Rule of 72 is a powerful tool for anyone looking to understand the impact of compound interest on their investments.

This simple formula can guide your financial decisions and help set realistic expectations for your financial future by providing a quick estimate of how long it will take for your money to double.

Whether you're saving for retirement, planning a major purchase, or just curious about how your money can grow, the Rule of 72 is an essential concept to have in your financial toolkit.