When the 'Rule of 72' FAILS!!

The ‘Rule of 72’ – ever heard of it?  The finance industry has been abusing and misusing this rule for years.  Many families are confused and are wrongly educated about this rule and believe the rule can be properly used in projecting a secured retirement plan.   In fact, this may be the largest misconception that I hear about when families come to our Secured Retirement Advisors offices for an initial financial review.

Nothing irks me more than a ‘so-called financial plan’ that relies upon a flawed ‘rule of thumb’ and flat projections for return rates. These misconceptions create unrealistic expectations and misaligned confidence and investors suffer.

What is the ‘Rule of 72’?

Investopedia explains that the 'Rule of 72' is a simplified way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors can get a rough estimate of how many years it will take for the initial investment to duplicate itself.

For example, Investopedia says that the rule of 72 states that $1 dollar invested at 10-percent would take 7.2 years ((72/10) = 7.2) to turn into $2 dollars.

When dealing with fixed rates of return, the ‘Rule of 72’ is fairly accurate. This chart compares the numbers given by the ‘Rule of 72’ and the actual number of years it takes an investment to double.

This rule works wonderfully as long as you can assume that your returns will remain level each year, or linear.  

The potential problem exists when an investor then takes this rule and tries to apply it to a variable rate investment, such as a mutual fund or equity portfolio, and assumes performance expectations based on level returns and a rule that results in a high probability of failure.

Misconception Example #1:

Here’s an example.  Think for a moment about your financial plan projections that rely on a ‘conservative’ 6-percent level rate of return over the next 25 years.

Your plan shows you investing an IRA of $100,000 dollars today

…and in 12 years your money doubles!

…in 24 years it doubles again!

And at the end of 25 years, your initial investment is now projected to be worth over $400,000 dollars!!  So is this a financial planning result that should be relied upon?

NO!! Because the expected rates of returns in an investment portfolio is variable (some years you earn more money, some years you earn less money and some years you may even lose money), the ‘Rule of 72’ breaks down and these results are unlikely.

Misconception Example #2:

Here’s another example.  Let’s compare two $100,000 dollar portfolios that average an 8-percent rate of return over a two-year period.   

The first portfolio will receive a fixed rate of return each year of 8-percent.  So after the first year the portfolio is worth $108,000 dollars and after the second year, it is worth $116,640 dollars. And after a total of nine years, the portfolio is worth $199, 898 dollars and the ‘Rule of 72’ results are fairly accurate, off only by $12 dollars..

However, the second portfolio is volatile and receives variable returns (think recent stock market returns). It receives a gain of 66-percent in year one, but a loss of 50-percent in year two. This portfolio also has an average return over two years of 8-percent.  However after two years, this portfolio loses $17,000 dollars.  The $100,000 dollars grew to $166,000 dollars after year one, and then dropped 60-percent to $83,000 dollars after year two. Worse, if you actually received these volatile returns your portfolio would only be worth $39,390 dollars after nine years, or 80-percent less than your expected result of $400,000 dollars.  Here the ‘Rule of 72’ was far from accurate and could spell disaster when planning for retirement.

Do not fall into the trap of assuming a level rate of return on an investment account that will actually fluctuate in its returns and do not make your long term financial planning decisions on an unrealistic investment ’rule of thumb’ that doesn’t account for probable market fluctuations.

This week, we will hear President Obama deliver his assessment on the condition of our nation’s finances during the annual State of the Union Address.  It’s a great time of year to assess your own finances. Visit with a professional financial planner that doesn’t rely on unrealistic projected rates of returns.  I also caution you - if a financial planner begins projecting your future account balances using the ‘Rule of 72,’ you may want to get a second opinion.