Rule of 72: Investment Magic3 min read
Ever wondered how much time it will take for your investments to grow given the current yield, rate of return of any asset?
If yes, then you have landed in the right place. We hear some insurance schemes and post office schemes market their product by stating the time it will take to grow your investments; yes, that’s psychological marketing.
One always loves to hear about growth of investments, but never go deeper in comparing and checking out the ‘ fineprints’ and opportunity cost of that investment asset class vs other investment class with the risk attached to every asset
So it’s a simple formula to ascertain the years needed for an investment to grow, simply divide the return on asset per annum (RoA) by 72. Lets say you invested in a NCD giving a yearly 9% yield so it will take 8 years to become 2X ( 72/9). Source: https://en.m.wikipedia.org/wiki/Rule_of_72
They normally say that an equity instrument should fetch you an annual return of at least GDP growth rate + inflation rate, so if the GDP growth rate is 8% and inflation grows at 5% per annum, ideally it should give a 13% return, but as you would have seen in history, equity markets do not work in a linear fashion, and simply assessing equity as an instrument on this formula on a year to year basis is wrong; ideally you need to sum it up for atleast 3-4 years to get to a proper equity return matrix.
Simply knowing how long it will take to grow will not benefit your portfolio; you must also consider these factors before making an investment.
- Financial goals: Every investment has a goal to fulfill; some goals are properly aligned, some are random in nature. It is highly advisable to set your financial goals with a certified financial planner, do a risk assessment and current asset classification, and then invest your money in any financial instrument.
- Time to achieve financial goal: If your financial goal is very short term, such as a winter foreign family trip, you should not invest that amount in risky assets until the goal is completed, but rather in an instrument that provides a fixed and safe return, such as a bank deposit.
- Opportunity cost: Everything in the world has an opportunity cost, whether it is your time, knowledge, or money. If you invest your money in an instrument that returns 9% while another financial instrument with similar risk parameters returns 12%, you have simply lost 3% of your opportunity cost, so you should clearly assess the other financial instruments available before committing to an investment.
- Taxation: The post-tax return is the actual return you would receive from a particular investment; currently, most debt instruments do not have indexation benefits; long term and short term capital gains are also important factors to consider before investing; it is recommended that you consult with your financial advisor or chartered accountant before investing in any instrument.
- Inflation: If your investment is not able to beat inflation till its maturity, you should give it a second thought before investing in any financial instrument, it is said that any instrument giving returns less than inflation should be clearly avoided until, there are other major benefits inscribed in the financial instrument
To summarize, simply knowing the rule of 72 will not help your investments; rather, it is more important to understand and evaluate other aspects of investments before committing your money to any investment instrument.
Happy Investing !