Hey Friends,
For this week I thought to share a financial tool that I picked up a few years ago in terms of how to decide where to deploy my monthly investment so that I can get better returns. Today’s is a slightly shorter article but hopefully useful and potentially one that will assist in making decisions.
Over the past few years, I have actively been using this tool called the Rule of 72. As a newbie a long time ago, I was always looking for tricks that long-term smart investors make use of that could help me make better decisions. The Rule of 72 is one such tool that everyone can make use of without too much thought and with time and experience can help build momentum in your wealth-building strategy.
So what is this Rule?
The Rule of 72 - Explained
In simple terms, The Rule of 72 is a simple method to estimate the number of years it will take to double an investment, given a fixed annual rate of return.
Even though this is an approximation, this is a great indicator of what time frame is required to either double your investment or what % of compounding return you will need to earn within a given time frame.
For example, suppose the annual rate of interest is 6%. According to the Rule of 72, the investment will double in approximately 12 years (72 / 6 = 12).
On the reverse side let’s say you want to double your investment in 6 years. Then you can simply use the same calculation and the answer is approx. 12%.
I have a cheat sheet that I use to make some “in the head” calculations and you can too. The column on the left is for the number of years needed to double, and on the right is the compound growth rate needed to double your investment.
2 Years - 36%
3 Years - 24%
4 Years - 18%
5 Years - 15%
6 Years - 12%
7 Years - 10%
8 Years - 9%
9 Years - 8%
10 Years - 7%
You can switch the columns around and alternatively take 36 years to double your investment at a return of 2% as an example.
How Can You Use it Regularly?
If you are early in your career, then understanding and using this tool can help you slowly build your wealth management strategy year over year.
If you are older and have been in the work environment for a while then you probably start to think about your accumulated financial net worth and what you will need to have saved up for when you would like to stop working.
I don’t use retirement or retirement age as the criteria anymore as I’ve observed that not a lot of people look to get to the retirement age before they stop working. The conversations have now shifted to “How much do I need to have saved up so that I can stop working”.
You can use this strategy to decide how much of your funds should you invest in the different asset classes (equities, cash/fixed deposits, bonds, crypto, commodities like gold, real estate, etc) to return a decent ROI (return on investment). Depending on your comfort, patience, and risk-tolerance levels you could choose a basket of different assets that could help you build your roadmap to financial nirvana.
Stocks have been one of the best asset classes to generate returns, and if you have the expertise to make the right choices then starting of early can help compound your investments over a longer period which means you may be able to achieve your financial targets sooner than later.
You could also choose very safe options such as Cash or Fixed deposits, and Treasury bonds which yield very little but this is also why it may always be prudent to get a mix of different asset classes so that you don’t get too deep on one strategy.
Other asset classes such as ETF’s, Index Funds, and Mutual Funds usually provide more balanced returns compared to Stocks or Deposits and bonds and hence is one of the vehicles used by a majority of the people starting their journey.
The Rule of 72 can help you decide where to deploy your resources, and how much to deploy. Putting more toward the higher-yielding classes allows the assets to grow and compound over time. As you grow in confidence and experience you can use varying strategies to make the right balance for yourself individually.
Mid-way through your career you would more than likely be generating more income than when you started. At that stage using the rule of 72 can help you focus your strategy on rebalancing and having a portfolio with a varying mix of assets that help you get to your goals faster.
Tools are meant to assist us in making decisions, they do not make the decisions on our behalf. As with all financial decisions, we are all individually responsible for the decisions we make, and hence building our own knowledge is a vital step in the journey. Any assistance from others is only to aid that decision making, and should not replace responsibility for our own money.
My Approach
I started my investment journey initially through mutual funds back in 2005 and that has been a consistent staple in my arsenal over many years. There have been periods where I had stopped it for various reasons such as changing locations, or changing job roles etc, but when I got the opportunity to reset and start again, I did.
A couple of years later I started to split investments between Mutual funds, and Stocks. I built experience through practice and made mistakes but used those mistakes as learning opportunities to improve my skills.
I gradually started to find that the investments in Stocks were doing considerably better over the longer term compared to the mutual funds with the added benefit that I was also earning dividend income from the Stock investments.
Progressively I also started to put money aside towards Fixed deposits and then I just manage contributions towards each looking at opportunities. If the deposit rates start to go up, then I divert a bit more towards those.
If I see opportunities with companies that are undervalued and not reflecting the true value then I seize the opportunity there based on my thesis for investing. And as a habit, I always have automated investments towards Index/ETFs so that I continue with that consistent behavior.
It’s not the amount that you put in that matters initially, it is the discipline to create that habit and the perseverance to build consistency.
Whenever I am at a crossroads to make a financial decision about where to invest my funds, I use the Rule of 72 to guide me in which asset class I have the best opportunity to double my investment and get me to my financial goals faster.
If I have to choose a deposit at 4% vs. a Stock where a company is growing over 20% year over year, then I would more than likely prefer to invest in the company as that would more than likely give me a better return than the 4% on deposits.
I don’t say this is the path that everyone else should choose, what works for me may not work for someone else as my risk and patience levels may be different for someone else. Also, the amount of time I have spent researching and learning about a company gives me a different perspective and confidence about my choices so blindly following someone else’s strategy is not the recommended approach.
Some additional tools that people use
Beyond the Rule of 72, other thumb rules can aid beginner investors. These include:
Rule of 100: This rule helps determine the proportion of investments one should allocate to equities. The guidance is to subtract your age from 100, and whatever you are left with is the percentage of funds that should be in stocks. This sort of follows the suggestion earlier that when you are younger, you would probably be better off with a higher allocation to stocks and that gradually you diversify the older you get.
Rule of 15x: Another rule that people use is concerning retirement planning. This rule is to save at least 15 times your annual salary for an ample retirement fund.
FIRE Movement Rule of 25: According to this rule, you should have around 25 times your annual expenditure saved up in investments. Withdrawing about 4% from this invested amount every year should keep you sufficiently covered for the rest of your life. Now, this rule was based on US inflation levels pre-pandemic and therefore needs to be taken with a grain of salt. With the sudden increase in inflation, these numbers may require adjustment, but even so, this is a decent indicator to tell you how short or close you may be to reaching your financial independence number.
Hope this article helps add another tool to your toolbox and helps put a few things in perspective. This is a marathon, not a sprint. Having a strategy for your path is important. In conversation and the occasional feedback with some of you, I realize that there are beginner investors and individuals who have not had a lot of experience in how to move ahead on their investing journey.
I hope articles like this provide a bit of guidance and perspective to help build the confidence to take your first steps and that I have inspired you to take action.
If you enjoyed the article, then please do give it a like, and share it with friends who may also be having doubts on how to get started. Also do provide your feedback if there are specific topics that you would like for me to cover, and I will make sure to include it in my planning for future articles.
For inspiration today, I would like to share a video regarding this topic I covered today.
Thanks for your time today.
See you in the next one!
Jithin
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