The Rule of 72

There is a handy little device, in the world of investing, called "the rule of 72". If you take the rate of interest, or other income, expressed as a percentage of your original investment, and divide it into 72, you will get the number of years it takes to double your money, assuming that all income is re-invested at the same rate. For example, let's say that you get an interest rate of 12%. If you divide 12 into 72, the answer is 6. Therefore it would take 6 years to double your money at 12%.

Let's take a closer look at compounding in this context. Let's say that you have $1,000 to invest, and that someone is willing to give you a guaranteed return of 12%, and that he will re-invest each year's interest for you and give you the same 12% interest rate on your re-invested interest, thereby giving you compound interest.

Year      Original          Rate of      Interest       Total
#           Investment      Return      Earned        Value
1           $1,000.00         12%           $120.00       $1,120.00
2           $1,120.00         12%           $134.40       $1,254.40
3           $1,254.40         12%           $150.53       $1,404.93
4           $1,404.93         12%           $168.60       $1,573.52
5           $1,573.52         12%           $188.82       $1,762.34
6           $1,762.34         12%           $211.48       $1,973.82

To use this example, you are just short of having doubled your money in 6 years. The rule of 72 isn't exact, but it's a great shortcut when you don't have a computer or a calculator handy. More importantly, this example shows you the importance of compounding interest. You get interest on your investment, and then interest on your interest. Your money works for you, tirelessly, and the longer you have it working for you, the greater your return will be.

The RULE OF 72 IN INFLATION

The Rule of 72 also works when you are estimating the effect of inflation on your purchasing power. Divide the inflation rate (say 6%) into 72 and you get 12.  That's the number of years it will take for your purchasing power to be cut in half -- assuming an average inflation rate of 6% over the 12 years.

Confused? Don't worry. Things will become clearer. I’m just trying to give you a little background information on some basic principles of earning money with your capital, or saving money on borrowings -- either way you will benefit.

INFLATION: A Pernicious Thief of Your Hard-Earned Money

Although inflation in the last couple of decades has been lower than in the 1970s and 1980s, eighties, it is still important to understand how your purchasing power is eroded over time by the compounding effects of inflation. While it is true that we do not suffer from the double and even triple digit inflation that many other countries in the world have endured, even an average rate of inflation of 5% can have far-reaching effects on your retirement or investment objectives.

There is a temptation among many of us to take the rate of return on an investment, subtract the official rate of  inflation, and expect that the resultant number is the rate at which our investments will grow. In other words, we expect that the difference between the rate of return and the inflation rate will improve our purchasing power by the resulting percentage as the years go by. It's not quite that simple.

I must warn you here, ahead of time, that you are not going to like what you see in the examples below.

Let's attempt an overview on the whole issue of how to deal with inflation:

In most instances, when your mutual fund salesperson approaches you with proposals for your retirement plans, the premise is usually that you will contribute a given dollar amount consistently over the number of years until your retirement. Then if the investment period is long enough, you will have accumulated a substantial amount of money. That is most certainly true. The combination of time and compounding can indeed be quite astounding in terms of the final value of your RRSPs.

However, the projections made by the mutual fund salespeople, and others who wish to help you with your retirement plans, don't usually deal with the decreased purchasing power of your plans over time. There are reasons for this.

First of all, if you factor in inflation, the final numbers are not nearly as dramatic. Secondly, no-one really knows what inflation is going to be over the long run. Is it going to average out to 3%, or is it going to be a lot higher or lower?  Or, what if there is deflation in our future instead of inflation? Who knows? Ask several different "experts" and you will get several different prognoses. Thirdly, there is no "standard" of looking at the effects of inflation -- at least not one that I have been able to find and that makes any sense.

In order to make the presentations here as accurate as possible, I decided to make a purely mathematical exercise out of the inflation issue. Let me explain.

If you really do contribute exactly the same amount of money (highly unlikely) every year for the years until you retire, it should be obvious that you are in reality contributing (say) $1,000 one year, $1,000 minus the effect of one year's inflation in the second year, $1,000 minus the effects of two years' inflation in the third year, and so on. In terms of purchasing power, $1,000 contributed in each of 5 years with an average annual inflation rate of 5% really amounts to:

First year            $1,000
Second year        $ 952      (1,000 divided by 1.05)
Third year           $ 907      (952        "        "  1.05)
Fourth year         $ 863      (907        "        "  1.05)
Fifth year            $ 822      (863        "        "  1.05)

After 5 years, the $1,000 contribution really only has the purchasing power of $822 in today's terms. In other words, if you really want your investments to grow in real terms, you have to contribute more every year than you did in the year before -- at least enough to cover the erosion in the purchasing power of each of your contributions due to inflation.

Here is a table which will explain a little more.

Assumptions:
Annual contributions of $1,000 each for 5 years.
Compounded Annually.
Interest rate of 10%.
Inflation rate of 5%.

Actual                Future Value              Value of Plan             Value After
Contribution      of Contribution           With Interest            Inflation
$1,000                $1,000                         $1,100                       $1,047
$1,000                $ 952                           $2,310                       $2,095
$1,000                $ 907                           $3,641                       $3,145
$1,000                $ 863                           $5,105                       $4,199
$1,000                $ 822                           $6,715                       $5,261
$5,000                $4,244                         $6,715                       $5,261       (Totals after 5 Years)

What does this table tell us? Although you have contributed a total of $5,000 in this scenario, the purchasing power in 5 years at 5% inflation has gone down to $4,244. The value of the plan has gone up to $6,715 because of the interest income, but the real purchasing power in 5 years' time is $5,261 converted back to today's dollars. To really compare apples and apples, so to speak, columns 1 and 3 show the actual contributions and the final dollar value, while columns 2 and 4 show the decreasing value of the contributions due to inflation, and the final after-inflation value in equivalent today's dollars.

The only effective remedy is to keep increasing your contributions to retirement plans to the maximum allowed by law, and to use every way possible of sheltering your income from tax.

Good luck! 

This article is adapted from a chapter of my eBook called The Success Primer -- Financial Planning for  Beginners.  You can get your copy of the entire eBook for free by signing up for the Next! newsletter here: www.nextnewsletter.com/promo.