24 September 2010

Rule of 72 and Rue of 72

So many years learning maths, but never once do I recall being taught the "Rule of 72".  But exploring the realm of investment, and the Rule of 72 would soon pop up on one's horizon. 

What is the Rule of 72?  It basically says that if you divide 72 by the rate of return (%), that would be approximately how long it takes to double.  Therefore, if one had $100,000 invested at a rate of return of 7.2%, then in 10 years, the $100,000 would have doubled to $200,000.  Sometimes, the Rule of 72 is referred to as the Law of Compounding.

Taking this idea and working it against my earlier posits, we would then arrive at the following:

Bank Savings Account.  Assumed 1% return.  Takes 72 years to double.  Dead by that time.
Fixed Deposits.  Assumed 2%.  Takes 36 years.  Halfway there.
CPF.  2.5% for OA, 29 years.  4% for SA/MA/RA, 18 years.  Not too bad.
SGS Bonds for 10-20 year tenure.  2-4%, 36-18 years.
Unit Trust - Money Market Fund.  2-3%, 36-24 years.
Unit Trust - Equities.  6-10%.  12 to 7.2 years.  Looks far more exciting.
Unit Trust - Bonds.  2-4%.  36-18 years.
Unit Trust - Balanced.  4-8%.  18-9 years.  Not bad.
Equities.  8-12%.  9-6 years.  Even more so.

Suppose then that you inherited $50,000 at the age of 15, and you kept it invested in some instruments that offered a return of 7.2% each year, then every 10 years, it would have doubled.  So:
   Age 25, $100,000
   Age 35, $200,000
   Age 45, $400,000
   Age 55, $800,000
   Age 65, $1,600,000
Sounds like an interesting deal?

Using the same 'rule', if one was taking a housing loan of $200,000 at an interest of 3%, then in 24 years, the total amount we would have had to pay would be $400,000!

So, if you were to stupidly owe a credit bill of $1,000 at an annual interest rate of 24%, then in every 3 years, it doubles!  In 12 years (doubling for 4 cycles), that $1,000 would have become $16,000!!

Consider, a car loan of $80,000 at an effective interest rate of 10%, in 7 years, it would be $160,000.  Hopefully, car loans will never reach that level.

Have fun with the Law of Compounding - a.k.a. the Rule of 72.

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