You Just Can’t Trust the “Rule of 72”
A basic rule of thumb for figuring out how long it’ll take for an investment to double in value is to divide 72 by an expected return. For example, if a client assumes an annual return of 6%, the so-called Rule of 72 suggests it will take 12 years for the nest egg to grow to twice its original size.
But advisors might want to warn clients to be careful about placing too much stock in this information calculation. In fact, the rule is so general that in practical terms it doesn’t live up to its promise, Westlake Village, Calif.-based advisor Neal Frankle writes in his Wealth Pilgrim blog.
For one thing, the rule doesn’t take into account taxes. And it ignores people who don’t reinvest dividends. Where these factors come into play, “your money won’t double as quickly as you expect,” says Frankle.
Besides basic math hiccups, the Rule of 72 skirts the whole issue of risk, according to Frankle. One investment may generate twice as much as another in raw returns, but it might also provide a bumpier ride over time. “You won’t realize that if you only consider this silly rule,” he says.
The rule also reinforces the dangerous assumption that returns are predictable. Other than CDs or short-term bonds, Frankle finds few investments to which the Rule of 72 can reliably be applied.
A better approach, he suggests, is figuring out whether a client’s asset allocation is realistic and if they’ve got enough income to last a lifetime. This means going beyond simple income multipliers to look at a person’s bigger-picture financial needs, according to the blog.
“The rule of 72 tells you how quickly your money will double,” writes Frankle. “So what? What are you going to do with the information?”