The Power of Compounding – The Rule of 72

We all know the principle of coumpound interest i.e. when interest that you earn begins to earn interest as well.

In investment, the returns that you earn on your investments can also be put to work to earn more returns.  This is called the power of compounding.

With the power of compounding, your money can really grow very fast and you can double your money at a faster rate.  You do not need to be a mathematics wizard to understand the power of compounding.

One of the ways to illustrate the power of compounding is something developed by mathematicians call “The Rule of 72″.  Here is how the rule works.

Divide 72 by the rate of return of any investment and the answer you get is the approximate number of years it takes for that investment to DOUBLE in value.

72 / Rate of Return = No. of years to DOUBLE money

An Illustration

Take a look at the table below:

An investor who leaves his money in a safe and secure savings account that earn 2 % per annum interest must wait for 36 years for his money to double in value.

Someone who puts his money into mutual funds or unit trust that pay an average return of 6 % per annum will be able to double his money in 12 years.  In 36 years, he would have doubled his money three times.

To illustrate further, let us see how two investors (Investor A and Investor B) would invest $50,000 over the next 36 years.

Investor A prefers to leave the money in a savings account to earn 2 % per annum.  His $50,000 will double in value to $100,000 in 36 years.

Investor B decides to invest in a fund that earns 6 % per annum.  His money will double every 12 years.  In 36 years, it will grow to $400,000.

There is a lot of difference between $100,000 and $400,000.  So whose shoes would you rather in?