Episode 67 – Why the rule of 72 feels like magic (but isn’t)
Episode transcript:
[music intro]
Jenny
Welcome back to Find Your Future with DRS. Today, we’re breaking down the rule of 72. This is kind of a thing I hear a lot of finance folks talk about, but it’s basically just a quick way to estimate how long it can take your money to double when your money’s gaining a certain percentage.
Seth
Yeah, it’s a quick way to think about compound interest. How long will it take for my money to double if I don’t do anything else and just keep it invested? And it’s earning a set rate of return over that time period?
Jenny
Yeah. So, Seth, do you want to just give us kind of the quick math example of how the magic number 72 works into all of this?
Seth
Yeah. So, the idea is that if you are earning an interest rate, you divide 72 by that interest rate, and that many years is how long it will take to double. So, if I’m earning a 9% interest rate, I divide 72 by nine. And that’s eight years. So, it’ll take my money to double in eight years. The way I like to think about it is if I’m earning a 7.2% interest rate, it will take ten years.
That makes the math easy. Or if I’m around a 10% rate, it will take 7.2 years to double. So the general idea is that if you have a set rate, so say you have 6% rate, it’s going to take 12 years. If you have a 12% rate it’s going to take six years.
Jenny
Yeah. And one of the reasons we wanted to talk about this obviously, is that it relates to money. It relates to DCP and all of these things. And sometimes it’s a good way to think about like, oh, should I put more money into my DCP account or even into my regular investments? You can say, well, if I’m earning a, say, 6% interest rate on my DCP right now, if I put in $100, that means that that $100 will double in the next 12 years.
Seth
Yeah, it helps you think about how your money is working for you. I oftentimes like to think about it in the opposite way as well. Like if I never put another dollar in, what could I expect in ten years or 20 years or 30 years if it doubles each of those ten years?
Jenny
Yeah, that’s true. And I think it’s used a lot in those folks that are especially planning for early retirement or that FIRE: financial independence, retire early kind of ideas. People are looking at how much money do I need to have in the bank that I cannot put another cent in and just live off of that particular interest?
Seth
Yeah. So, I’ve done this sometimes, like when I’m awake at night and can’t sleep and think like if I were a 30-year-old and I had $100,000 already invested. We, we did a book review of what was the name of that book? The Financial Feminist, by Tori Dunlap.
She was talking about one of the things that she really tries to encourage people do is get to your first $100,000, because then once you have that money, it really starts working for you. And so, if somebody was aggressive, really young and was able to save $100,000 by the time they were 30, and then they were just earning 7.2%.
So, it doubles every ten years. So then at age 40, they have $200,000. At age 50, they have $400,000. They live to 100: $12.8 million. And that’s the thing. Like it’s really those last couple of times it double if you live a long time and you haven’t touched that money. Obviously, a person who reaches 65, 70, they’re probably going to start taking some of that money out.
You’re going to have to start taking required minimum distributions, but it just shows you how powerful compounding can be, especially over a long period of time.
Jenny
Yeah, and especially from an early age. And that’s why I think this comes up all the time of trying to push people that are under 35, especially to, you know, set any kind of money you have extra aside now. Not to say that you have to like, live off of ramen and withhold those, you know, certain fun things.
But really thinking about putting some of that extra money aside so that it can double over the next ten, 20, 30 years.
Seth
Yeah, I think that’s the thing that can be so powerful for folks, too. If you save earlier, you will have less need to save later on because you have the benefit of time working for you. The other thing that I think can be beneficial to think about with the rule of 72 is when you think about like inflation or think about low small interest rates.
So, 72 if you divide it by three, so you say 3% is the rate of inflation. So, 72 divide by three is 24 years. So, if inflation is 3% you can expect prices to double in 24 years. So, people [say] “oh I remember when a gallon of gas was only $2 and it’s $4 now.”
Well, if that was 24 years ago that’s actually about right. That’s kind of the normal what you would expect in the course of inflation. If it is around 3%, you would expect prices to double between the time you’re a teenager and your middle age double once in that time period. So that’s a normal rate of inflation, 3% or 2.5% or 4% somewhere in that kind of around 3%.
So that way you can think about this. The other thing, I went down a crazy rabbit hole last night because I love math, and I was trying to remember why the rule of 72 works and everything I read reminded me it’s just an approximation and actually it’s more precise if you had a rule of 70. That’s a little more accurate.
But 72 is divisible by a lot of different numbers. You can divide it by two or 3 or 4 or 6 or 9 or 8. Whereas 70, you can only divide it by 7 and 10 and 2 and 5. There aren’t as many options. That’s another reason the rule 72 oftentimes gets brought up, but often times you’re just thinking about 8 or 9%. Eight years: 9%, or 9 years: 8%.
Jenny
Yeah. And you can find stats on the internet where it’s like if you look at the general growth of the stock market over the last hundred years, it has grown at a rate of somewhere between 7 to 10%. And so that’s one of those arguments. You know, I have friends that are like, “oh, the stock market’s a pyramid scheme.” I’m like, “no, it’s not!”
Seth
Well and I think that’s the other thing to keep in mind is that even if you’re earning 6% and oftentimes people would say that’s pretty conservative, it’s still going to double in 12 years. Yeah. It’s not 8 or 9 years, but it’s still pretty quick an entire lifetime. If you’re if you’re started off saving at a younger age. So, it can be helpful to see between 6%, 8%, 9%, 12%, the doubling happens a little bit more quickly.
And if you live a really long time and earn that higher rate over a really long time, it’ll, you know, you’ll have a couple more chances to double. But the power of the compound interest is really about the number of times you get to double.
Jenny
Yeah. And obviously the younger you are, the more your money can double.
Seth
Yeah. Yeah, exactly. But I think even for our folks who are closer to retirement thinking about, you know, it’s you mentioned your deferred comp balance or your plan three balance at age 60.
Jenny
Yeah.
Seth
If you don’t plan on touching that money until 70 or 73, when you have to start taking required minimum distribution, it’ll likely or could double in that time.
Jenny
Yeah. From age 65 to 75.
Seth
Yeah. I think sometimes people look at their balance and like, “oh, I wish it was bigger. It’s $250,000. Am I going to be able to live off that in retirement?” Well, if you’re not going to touch it for another ten years, yeah, maybe $500,000 makes you feel a little bit better or a little bit safer. Now, inflation and there’s other things that are balanced with that.
But oftentimes we’ve been talking about over the last couple of months thinking about when do you need the money. It’s like a big part of the conversation. Yeah. Saving it in your 20s and 30s, you don’t know when you’re going to need it.
Jenny
Yeah. And like you said, as a state employee, if you’re vested and you’ve worked a number of years, hopefully you’re already collecting that pension at 65 and then you hopefully can kind of set aside some of those DCP funds for a couple years to grow a little bit more.
Seth
Yeah, I think that’s a really a topic for a different discussion. And we talked a little bit with Kirk from the Social Security Administration about this, about also deciding when you’re going to start collecting your Social Security. Like there’s a lot of different factors to take into consideration there.
Jenny
Yeah.
Seth
But yeah, you’re right. The rule of 72 is oftentimes shared in personal finance circles when really it’s just an example of compounding. It you don’t have to like have the rule memorized or anything. But it’s just a quick shorthand once again approximation of and you know, you’re never going to have perfect 8% returns every year for nine straight years.
Jenny
Exactly. That’s a good point to mention that obviously, we know that markets fluctuate. It’s not always going to be the same percent of interest, but it just gives you an idea. Yeah. And hopefully a little bit of a motivator. And for all those of us who do not particularly love to do the math, there’s tons of charts online.
If you just Google the rule of 72, you can see an easy chart of how that transfers over. Or even better, use a tool out there like a compounding interest calculator. You can put in: ‘I have this balance.’ We even have one on the website the DCP calculator. You know you can say ‘this is my balance in DCP.’ Here’s the percentage rate that I’m getting right now. And your DCP account can tell you that what your percent is. And you can see how much it’ll grow over the next ten, 20, 30 years.
Seth
Yeah, exactly. Yeah. Project out to the future. Be excited to continue to save more.
Jenny
Yeah, exactly.
Seth
All right, Jenny, anything else about the rule of 72?
Jenny
Well, of course, always. If, if folks have questions about this or any other finance questions, you can send us an email to drs.podcasts@drs.wa.gov.
Seth
Perfect. Thanks.
Jenny
Thank you!
[music outro]
Disclaimer
Thanks for listening. And now we’d love to hear from you. What topics would you like to hear about? What questions do you have for us? Send an email to drs.podcasts@drs.wa.gov that’s drs.podcasts@drs.wa.gov. The Department of Retirement Systems provides this podcast as a public service, but it’s neither a legal interpretation nor a statement of DRS policy.
References to any specific product or entity do not constitute an endorsement or recommendation. The views expressed by guests are their own, and their appearance on the program does not imply an endorsement of them or any entity they represent. Views and opinions expressed by DRS employees are those of the employees and do not necessarily reflect the view of DRS or any of its officials.
