Lessons from the rule of 72
A quick take on how the rule of 72 helps investors understand the pathway to building wealth.
The rule of 72 is a simple concept. To figure out how long it takes for an investment to double simply divide 72 by the return. If you manage to achieve a 10% annual return an investment will double in 7.2 years. Simple enough. But like everything in investing some additional nuance helps.
How quickly you double your wealth is driven by asset allocation
Every year Vanguard releases a chart of 30 year returns for different asset classes. Using the rule of 72 an investment in each asset class would have taken the following number of years to double based on the 2024 edition of Vanguards chart:
This is one of the most important lessons for all investors. Asset allocation matters far more than picking individual securities for your portfolio. The mix in any portfolio will have the biggest impact on outcomes obtained.
According to the University of Queensland the average Australian works for 45 years. Assuming returns over the last 30 years continue in the future an investor in US shares could double a portfolio 6.94 times during their work years. An investor who remained in cash would double their portfolio 2.62 times.
This assumes that an investor had a portfolio at the beginning of a career and doesn’t take savings into account. Yet the point remains – the ‘safety’ of more conservative investments does not translate into safety when considering life outcomes.
Don’t forget about inflation
The first chart does not take inflation into account. And we can’t forget about inflation. The reason all of us save and invest is to grow our money so we can spend it later. The purchasing power of our assets matter.
The previous chart showed nominal returns. The picture is different if we use real – or inflation adjusted – returns. These returns represent how much purchasing power will increase.
This profoundly changes outcomes and further reinforces the need to focus on asset allocation. When inflation is taken into account it demonstrates how critical it is to invest in growth assets over the long-term. Real returns for US shares are 24% lower compared to the nominal return. Real returns for cash are 64% lower than the nominal returns.
This is mathematically obvious as accounting for inflation takes away more of a lower nominal return than a higher nominal return. But intuitively many investors struggle with conceptualising this arithmetic.
Building wealth is the process of amassing financial assets or passive income to create independence. When we use the rule of 72 to explore how many years it takes to double the real spending power of a portfolio it becomes painfully obvious that it is impossible to build wealth by investing in defensive assets.
It takes more than the working lives of most Australians to double wealth in cash. With Australian bonds an investor can’t even reach 2 “doubles” of wealth in a working lifetime. Considering the rule of thumb is to have 25 times your spending needs saved for retirement there is no way to realistically save enough to make up for not investing in growth assets. Forget about retiring early.
Defensive assets feel safe over the short-term. They provide security. This feels like the right trade-off to make for people who fear the volatility of the share market. The logic behind this view is based on how the trade-off is framed. And this matters. A better way to frame the trade-off is if you want the perception of security or actual security.
The rule of 72 is a good rule of thumb to frame these trade-offs. Unless you are fortunate enough to start life with significant financial assets building wealth requires doubling your assets multiple times over your lifetime. Saving money matters. But ultimately it takes investing in growth assets to get to a position where your financial position enables independence.
What other rules of thumb do you use to stay on track to build wealth? Let me know at [email protected].
