Whenever I’m scrolling through the posts in business or entrepreneurship groups on Facebook or other online forums, I inevitably come across a question from someone that goes something like this:
“I have [Insert amount of money] and want to start investing in [Insert asset class] and don’t know where to start. Any advice?”
This question is, to say the least, a wee bit broad.
There’s such an incredibly wide array of attributes and concerns specific to every individual that customizing an investment plan for such a person based off of such scant information is impossible. Or, at least, it’s impossible to do so in a way that’s actually helpful.
That being said, there is a simple rule that is a good place to look when you “don’t know where to start.” This rule allows new investors to better hone what kind of returns (and thereby risk) they should seek when investing in order to meet their individual goals.
And that rule is The Rule of 72.
The Rule of 72 is pretty straight forward, it goes like this:
So, for example, if you are getting a six percent interest rate, it would look as follows (I should note the Rule of 72 assumes compound interest).
72 / 6 = 12 Years to Double
To see it play out, here’s the year-by-year breakdown with a $100,000 investment:
Yup, it doubles in 12 years. So, it’s an older rule but it checks out.
The reason this rule is so helpful is that it makes it crystal clear how important your rate of return is and what kind of returns you should be aiming for to hit your goals. If you want to get rich, settling for conservative returns is not going to do it. On the other hand, if you are relatively young and want a comfy retirement, you don’t need to be particularly aggressive.
It’s also important to note two things to round out the picture: 1) Nominal vs Real Returns and 2) Buffett’s First Rule of Investing.
Nominal vs. Real
It’s nice to make more money but if everything costs more as well than it’s not that helpful. So remember that inflation has historically been around four percent (with a lot of variation) and is substantially higher now.
The nominal rate of return is just what the return is. In the above example, it would be a simple 6 percent. If, however, the inflation rate is three percent, then the real rate of return is only 3 percent (6 minus 3). Thus, a more accurate Rule of 72 with the above example would use the real return and divide 72 by 3. In that case, it would take 24 years to double your money (in real terms).
Of course, the inflation rate is more like 7.5 percent right now so that is something to keep in mind.
Buffett’s First Rule of Investing
Warren Buffett’s famous first (and second) rule of investing go like this:
“The first rule of an investment is don’t lose [money]. And the second rule of an investment is don’t forget the first rule. And that’s all the rules there are.”
The reason he stresses this is because it is really hard to catch up if you lose your principal. Indeed, just look at this chart to get an idea of what your return needs to be to break even with a variety of losses.
If you lose seventy percent of your principal, you need a ridiculous 233 percent return to get back to square one. Not something that can reasonably be found.
Thereby, you should hesitate to engage in highly risky investments even if there is a large potential upside. Perhaps you can use the barbell strategy and make risky investments with a very small percentage of your portfolio. If you had, for example, bought some Bitcoin in 2011, with five percent of your portfolio, you would have made a fortune. But had you lost five percent on some "shitcoin,” well, life goes on.
But overall, you should avoid risky investments and stick with Buffett’s first rule… and his second rule for good measure.
Conclusion
The Rule of 72 allows investors to target rates of returns based on what their goals are. In that way, it’s a very helpful planning tool. It’s also good at forcing investors to think about what exactly those goals are as many haven’t even gotten that far. But that would require a whole ‘nother article (or book maybe?).
Just remember to adjust for inflation and use real numbers. And protect your principal! With those things in mind, the Rule of 72 makes for a great tool in the investors toolkit.