Deeper Dive in The Rule of 72 Part II

In part one the example of a 14 year old who invests $5000 one time of the money earned while babysitting showed the power of compounding over a long period of time. Of course as effective as it to invest one time for a long period of time is the most effective way to make use of this is to do the same process multiple times .

Parcheesi with 72 Spaces

Double Stacking

The next most powerful concept when using the rule of 72 is the idea of consistent and continuous investing. Suppose our 14 year old was to continue on the path of saving and investing as a 15 year old? Then there would be two sets of investments working in parallel with one year between them.

Using the rule of 72 at age 22 there would be some doubling of the investments of $5,000 at 14 and the $5,000 at 15. They would each have become $10,000 by then and there would be a little over $20,000 by 22. (Of course this is a simplified example where we are compounding once a year and not taking too much account for stock market fluctuation. ) $20,000 is a decent 20% down payment on a $100,000 starter home. This would leave $80,000 left to deal with to pay off. The initial money invested was only $10,000 or 10% of the value of the starter home.

Winning Formula

Suppose our mythical 14 year old investor decided putting $5,000 aside to invest from age 14-21. What would the effect be on a $100,000 house purchase? Just with the money put aside $5k X 8 years = $40,000.

Now lets look at the investment gain side of the formula. Each $5k doubles at 7.2 years. If an investment didn’t get to 7.2 years at a particular time it would be at some portion of the doubling cycle. So at age 22 the money put in at 14 would be doubled while the money put in at age 21 would be just 1/7th of it’s doubling gain.  The collective gain at age 25-26 is something interesting to look at.

A starter home of $100,000 could be paid off by the principle investment and the gains made by the consistent investments over the 14-21 year ages. The initial $5k put into the investment pool doubled to $10k at 21 and is close to doubling again to $20k at 26 years old (28.4 to be precise).

What if our 14 year old was to put a little extra each year with the extra income earned? Suppose the teen was able to put $1,000 extra for age 15 & 16, an extra $2,000 for 17 & 18, $3,000 for 19, 20, & 21? What would the numbers look like then?

This higher starting principle number of $55k gets the bucket to more than halfway to the $100k house. When the investment gain is put into the equation look at the results:

The goal is reached by the 24-25 year age range. What 24 year old would not want to own a house free and clear?  If a little more patience is used by age 26 when the bigger principle investments double the money grows by about 50% to $146k.

Retirement Applied

Let us look at the formula put towards traditional retirement rather than a house purchase.

Between the 60s to 70s the initial investments have 6-7 cycles of doubling. At 65 the initial $5k has grown to $640k. The first two years by 65 have collectively grown from $11k to $1.4 million. By just adding up all the 7th cycle totals the grand total at the end of the cycle would be $7,040,000. Keep in mind this is without adding any money after age 21. The initial outlay was $55,000. This is the rough result of compounding over a long period of time.

Against Time

What if you are not the young little 14 year old? What can the rule of 72 do for you?

The IRS maximum contribution level is about $18k  for a 401k so if you were to contribute the max from 50 -57 years of age then collectively by the end of the second doubling cycle there would be $576,000. Not the super with time result of the 14 year old babysitter but, nothing to sneeze at either. Of course if you work a few more years the more that can be added to compound and the bigger the total. A tax deferred or advantaged account may have some other gains as well.

Comparing

The main advantage of the rule of 72 is the ability to run scenarios of predicting levels of wealth growth over time based upon interest rate and initial principle investment. One investment can be compared to another investment based upon a longer term view. This shows the power of savings rates.

The power of savings rate can not be over emphasized. Think if normal person has about 5.5% savings rate, how much can be accumulated? The median household income is $55,775 per year. The savings per year is $3,067 per year based upon these numbers.

Let’s look at our 14 year old again using the previous numbers and the median numbers:

$5,000 Initial Investment

 

$3,067 Initial Investment

(based upon median income & average savings rate)

The difference is more apparent when looked at through the magnifier of time. Most people are not at the 14 year old age so the savings rate becomes more critical if the goal is to save for retirement or a big purchase. Most financial planners recommend to put between 10-15% savings towards investing for retirement.  (This is $5,577 – $8,366 per year.)

15% Average Annual Income invested at 25

Beyond Recommended Average

What if each factor is optimized for where you are right now? Can you ask the right questions to get better answers? The three factors of the rule of 72 is time, interest rate, and investment rate.

Time can not be reversed so the next best thing is to make an action in the right direction right now. Action trumps non-action. If nothing is done nothing happens. This is common sense but, it is crucial if you want time to work for you instead of against you.

Interest rates need to be looked at to see the doubling time. A savings account of 1% takes 72 years to double while an index fund that returns 10% only takes 7.2 years.

The last but the most effective way to increase the bottom line is to juice the investment rate. The investment rate it the rate you are able to control and adjust of all the factors. The investment rate is directly correlated to the savings rate. The savings rate is directly correlated to the income spending difference.

There is nothing earth shattering with these concepts.  What if you are an average American couple; both spouses working and spending both incomes. What if the couple was to live off of one income. The average individual annual income is $32,140 . If this is subtracted from the median household income of $55,775 the result is $23,635 to invest. How does that pan out?

This is only the result of one year of living off one income now think if this is done just for 5 years (25-30 years old)

This same couple in their 50s after the 4th cycle have accumulated at least  2.26 million dollars. This means the couple would be millionaires in their 40s (Rule of 72 in 3rd cycle is $1.13 million)

Rule your finances with the  Rule of 72…

 

 

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