This post was originally written by Rudy Luukko, editor, investment and personal finance, Morningstar Canada.
The rule of 72 is a handy mathematical shortcut for estimating how long it'll take to double your money if you stay invested and reinvest your gains.
What it fails to do, however, is present accurately your future purchasing power.
The "magic of compounding" isn't so magical once you take account of the impact of inflation. And if you are investing in an instrument like a fixed deposit, in which the returns are taxable, even more of the magic is lost.
The rule of 72 is a very simple calculation. By dividing 72 by the annual rate of return, investors get a rough estimate of how many years it will take for the initial investment to duplicate itself.
First, you make an assumption as to what your average annual percentage return will be on your investment. Then you divide this average assumed return into the number 72. The answer will be the number of years it will take to double your money.
For example, let's assume an average 6% return. At that rate, according to the rule of 72, it would take 12 years to double your money (72 divided by 6).
But while a 6% return will double your money in nominal rupee terms over 12 years, this timeline is very likely to fall well short of doubling your purchasing power. The reason: inflation.
So if 72 isn't a good "rule" for estimating how long it takes to double your purchasing number, what is?
"The rule will be higher or lower, depending on the rate of inflation we assume," says Shailesh (Shay) Kshatriya, director, Canadian strategies at Toronto-based Russell Investments.
Using 72 would make sense if zero inflation were assumed. Assuming a deflationary period, the appropriate number to divide by could even be below 72. "However, the economic implications of deflation are not necessarily positive, especially if deflation persists for an extended period," Kshatriya notes.
Under the most probable economic and market scenarios, which assume a rising cost of living, the inflation-adjusted number for calculation purposes is likely to be well above 72.
For instance, if we look at the current market environment in Canada, Kshatriya's calculations produce a rule of 112 for estimating how long it would take to double your purchasing power if investing in Canadian equities that earned a market return. This number, which he emphasizes will vary as inflation assumptions change, assumes an average inflation rate of 2.5% annually over the next 20 years. If we assume an average annual return of 7% over that period, it would take 10.3 years to double the value of an investment before taking inflation into account. (The rule of 72 is used to obtain this figure: 72 divided by 7 equals 10.3.)
But to determine how long it would take to double the investor's purchasing power after assuming 2.5% inflation, Kshatriya's rule of 112 comes into play. Using this number, it would take 16 years to double your purchasing power from an investment returning an average 7% annually. (This is calculated as 112 divided by 7, which equals 16.)
The lesson for investors is that they may find themselves financially unprepared if they base their wealth-creation assumptions on before-inflation numbers, and on the rule of 72. Kshatriya recommends that advisers play an "expectation manager" role, educating their clients by illustrating the actual impact of inflation on long-term investing.
This post initially appeared on Morningstar.ca and has been edited for an Indian audience.