Rule of 72

Those who watched the final week’s episodes of Kaun Banega Crorepati will recollect there was a participant named Mahaveer Prasad (age 25 years) from a village in Rajasthan.  He won Rs. 6,40,000.  The unique thing about the participant was his approach to the money he will be winning from this contest.  Generally, the participants want to pursue their goals from the award money or to go for a world tour or to just save for future.  However, Mahaveer Prasad was much clear in his approach and stated that he will not expense out any money he wins.  He will save and try to double, triple or quadruple it.  When asked about how this can be achieved, he says that he will save it in bank deposits and after 8 years, the money will automatically be double!

Without going into whether this way is the most efficient way of doubling the money, we should appreciate his intention and clarity in investments.  At a young age of 25 years, he knows that he wants to save the money and want to grow it.  This he knows can be done through investment in instruments like fixed deposits and the money doubles after certain number of years.

 

The time period to double the money will vary depending on the type of instrument chosen for investment.  Further one need to consider the incidence of tax on the interest or profit generated.

The important point to note here is how simple is it to double one’s money within certain number of years.  Yet most of us just try to ignore investing since we do not know how our investment will look like after few years.  This uncertainty procrastinate the investment decision making.  It helps to visualize that by investing in a particular company’s bond, my money will double in 9 years.  This way we know the time frame as well as the final value of the investment.

The Rule of 72 helps us in visualizing how our investment will be after a certain time period.  This is a simple rule which tells how long will it take to double your money if you have it invested at a certain interest rate.  You just need to divide 72 by the rate of interest offered on the instrument.  The answer is the number of years it takes to double your money.  For eg:  If you earn an interest of 8% on a fixed deposit, your money will be double if you stay invested for 72 divided by 8 i.e. 9 years.

This assumes you keep on reinvesting the annual interest earned at the same rate and ignores the tax aspect on income.

This rule can be handful in comparing various investment products.  In case your goal is to double or quadruple your money to buy a car or your dream home, you can calculate the number of years it will take by this formula.

The table below shows the number of years it takes to double the money at various rates.

Rate of Return	No. of Years
5%	14.40
6%	12.00
7%	10.29
8%	9.00
9%	8.00
10%	7.20
11%	6.55
12%	6.00

Where you aware about the rule of 72?  Whether visualizing your money after the investment horizon helps you in making investment decision? Do share your comments and suggestions below.

The Power of Compounding

There is an Internet story going around about a poet who, due to hard times, was no longer able to feed his family. A King, pleased by his recitation, asked him to name his reward. The poet, pointing to the chessboard said, “If you place just one grain of rice on the first square of this chess board, and double it for every square, I will consider myself well rewarded.” King was surprised by this and asked the poet to reconsider his reward. However, poet was satisfied with this reward.

King ordered his courtiers to start placing the grain on the chess board. One grain on the first square, 2 on the second, 4 on the third, 8 on the fourth and so on. The number swelled to 524,288 grains on the 20th square. When they came to the half way mark, the 32nd square, the grain count was 2,147,483,648 i.e. more than 2 billion and soon the count increased to lakhs of crores. Eventually the hapless King had to hand over his entire kingdom to the clever poet.

The story ends with the moral - “Never underestimate the power of compounding. If you stay invested long enough, it’ll work for you. A small sum invested every month from the beginning of your work-life can lead to a very impressive amount at the time of your retirement.”

The power of compounding can work magic to your wealth. It, along with the benefit of time, can multiply your investment.

Let us consider a hypothetical example of Anil and Sunil. Anil started investing Rs. 5,000 per month from the age of 25 years, whereas Sunil was a spendthrift in his early life and started investing at the age of 45 years. He thought by investing more (Rs. 11,667) till the time of his retirement, he will manage to invest the same amount as Anil till retirement. We assume both earn the same amount on their investment, @ 10% p.a. Let us have a look at how their investment grows.

	Anil	Sunil
Investment Start Age (in year)	25	45
Investment amount p.m. (in Rs.)	5,000	11,667
Retirement Age	60 years	60 years
Profit / Interest rate	10%	10%
Total Principal Investment (in Rs.)	21,00,000	21,00,000
Wealth at the age of 60 (in Rs.)	1,89,83,190	48,35,626

HTML Tables

The difference is startling. Anil’s wealth at the age of 60 years is Rs. 1.90 crores whereas Sunil’s wealth is just Rs. 48 lakhs even though both have invested the same principal of Rs. 21 lakhs till their retirement. Anil’s wealth is little less than 4 times the wealth of Sunil.

The above illustration shows the benefit of compounding and investing early. Ideally one should start investment the moment the first salary cheque is received and should continue it periodically.

To benefit from compounding, start saving right now. Determine the amount of monthly savings required to achieve your lifestyle goals and allocate it to different asset class as per your investment and risk profile. Start investing the monthly savings to these assets class by way of standing instructions to Bank and by authorising your Financial Advisor.

Do not know how to determine your investment and risk profile and the amount of monthly savings required to achieve your lifestyle goals?  Don't worry.  Bachhat will cover all this and much more in subsequent posts.  

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