Help your Money Grow: May the Force (of 72) be with you
“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.” – Albert Einstein
In Douglas Adams’ bestseller, “The Hitchhikers guide to the Galaxy”, the magic number that unlocked the universe’s answers was 42. Adams was asked many times why he chose the number 42. Many theories were proposed, including that 42 is 101010 in base-2 binary code, that light refracts through a water surface by 42 degrees to create a rainbow and Adams rejected them all and said that the answer to this is very simple. It was a joke.
However, when it comes to investing and finance, the number 72 is truly a magic number and no joke. While a spreadsheet or a scientific calculator can calculate compound interest, the number 72 gives you a simple calculation on when your money can double after compounding over the course of several years. Here is an example:
You have invested $100,000. Let us assume that the money grows at 6% annually. Quick, how long before it doubles as in the $100K becoming $200K. Before you go looking for a logarithmic calculator or open up an Excel spreadsheet, here is simple math using ‘magic number’ 72:
The number of years for the $100K to double to $200,000? 72 / 6 = 12 years. That is, divide the number 72 by the interest rate. What if the interest rate is 8%?
Then, the answer is 9 years, which is 72 divided by 8!
The point here is that money saved early on in life can grow to a much larger number, over the years. Some of us may have started later in life, and better late than never. It is never too late (or too early) to start saving, although the catch up amounts will have to be higher for those who start saving later in life.
The rule can also be used to find the amount of time it takes for money's value to halve due to inflation. If inflation is 3%, then a given amount of money will be worth half as much in 72 ÷ 3 = 24 years. For those of you keeping money in the proverbial mattress (or in the 0.1% per year ‘savings account’), inflation is the silent killer that eats away at savings that are growing at a rate lower than inflation.
Consider the these three examples to get to the Million dollar savings mark by age 65:
Sally starts saving $700 per month when she turns 30. Assuming a 6% rate of return, she will have a million dollars by the time she turns 65.
Sally’s friend Jane starts getting serious about saving for retirement only at age 40. Again, assuming a 6% rate of retirement she will need to save about $1450 a month to reach the million-dollar mark by 65.
Another friend of theirs, John, starts saving only at age 50 due to several reasons. He has a more uphill task of reaching the 1 Million dollar goal by 65. Assuming a 6% rate of return, he will need to save $3500 per month to get to that mark.
Did you know?
Almost 54% of respondents to a Federal Reserve survey indicated that they had no retirement savings or deferred compensation plans like the 401K, 403(b), among others. More than 40% of those with $100,000 annual household income indicated that they had no 401K.
About 45% of respondents to the survey said that they expect to work in retirement as a source of income in retirement.
20% of respondents had less than $50K in retirement savings, 30% had between $50K to $500K in savings and only 9% had more than $500,000 in retirement savings.
While the general retirement outlook in the US is not very comforting, starting early and leveraging the power of compounding helps in building a comfortable nest egg. That means discipline and spending less than what we make. It is never too early or too late to start!
The power of 72 offers another advantage in terms of dollar cost averaging through the ups and downs of the markets – when the market is down, your fixed dollar amount buys more and when the market is high, it buys less. However, you are still investing the same dollar number.
Dollar cost averaging involves continuous investment in securities regardless of fluctuation in price levels of such securities. An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets. Investing involves risk, including possible loss of principal.
The examples listed herein are hypothetical and are not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
This write-up is for educational purposes only and should not be considered financial or tax advice.