There are many lessons to be learned in this world. Some of them taught in classrooms, others in life. The best ones are those that carry substance yet are simple to understand. One of the most useful lessons I have learned is what is known as The Rule of 72. It is a simple and effective way to easily understand some of the financial jargon many salesman like to throw around these days. It is also a great way to break down what seems to be complex financial calculations into understandable math.
The Rule of 72 is a mechanism of measuring how many years or return per year [%] it would take to double an investment. I will illustrate with a few examples.
Using Number of Years:
Initial investment: KD 100
Investment Horizon: 10 Years
Annual rate of return [ROR]: Unknown
In this case you are presented with an investment whereby you have been told that the investment would require KD 100 and you would leave the investment for 10 years without touching it.
What would be the annual rate of return needed in order to double the initial investment to KD 200 by the end of 10 years?
Simply divide 72 by the number of years to get the answer: 72/10 years = 7.2% annual ROR. That means that if the investment returned greater than 7.2% on an annual basis you would expect to double your initial investment of KD 100 earlier than 10 years.
Using Rate of Return:
Initial Investment: KD 100
Investment Horizon: Unknown
Annual Rate of Return: 20%
In this example we assume that you are able to achieve an annualized return of 20% on your initial investment. The Rule of 72 will enable you to quickly calculate how many years it would take for the investment to double. Please note that the annual rate of return is also interchangeable with the IRR [Internal Rate of Return] that many salesmen in finance like to throw around.
How many years would it take to double the initial investment of KD 100 if the 20% IRR is maintained?
Again, we take 72 and divide it by 20% [do not use decimals] to get the answer. Therefore, it would be 72/20 = 3.6 Years. In other words it would take 3 years and approximately 7 months to end up with KD 200.
To my knowledge 72 is the only number that possesses this magical financial prowess. It is a rule that has served me well in my finance career. I urge you to embrace it and I guarantee your financial world will be that much simpler.
Enjoyed this brief lesson as I wait for the dead cat to bounce.
Boubyan bank is offering me a money market fund with a %9.2 weekly ROR. What do you think? Is this a scam of some sort?
Link:
http://www.bankboubyan.com/fund_kwd_ar.htm
Thanks
Nubo: I wouldn’t say its a scam. However, to be able to achieve that ROR they would be taking on more risk [ie corporate bonds etc]. Also, make sure the fund does not have a gate provision. This means that they could suspend redemptions.
The magic number 72 time to break it down
(2x) = x*(1+interest)^years
2 = (1+interest)^years
ln (2) = ln (1+interest)^years
.693 = Years * ln(1+interest)
If the interest is small then it is valid to say
.693 = Years * Interest
Convert Interest into none decimal
69.3 = Years * Interest
It is the rule of 69
Econ’s being a bit dense and lazy they like simplicity 72 closest divisible number.
Good old days when math was the Guru’s 1st language.