Explaining The “RULE OF 72”
Will you want to alter your lifestyle a few years from now?
Let’s say you’re now forty years old. You’re single with an annual income of $35,000. Your closet holds clothes you adore, you eat out occasionally, go to the movies on weekends, go to concerts every now and then, and enjoy a vacation away from home once a year.
Or perhaps you’re married with a joint income of $60,000. You and your husband go away to a country cottage on weekends, drive two cars, play tennis and golf, entertain friends, and travel each year.
Now, how much cash will you need in order to continue that lifestyle once you stop working? The temptation is to say, “A lot.” But how much is a lot? And where is it going to come from? There’s an old saying about how you find wealth: You can marry it, inherit it, or earn it. (Of course, you can also steal it—but stealing rarely works for long, and we’re going to keep things honest here.)
Let’s say the only wealth you have and are likely to have is what you earn. And with your $60,000 salary, you spend about $4,000 a month for mortgage payments or rent, car payments, clothes, food, entertainment, and credit cards. To maintain this lifestyle, you’ll need to have invested $600,000 by the time you stop working so that at a (fairly typical) 10 percent rate of return, you and your husband can continue to receive the same income as you do now— $60,000 a year.
Similarly, with a yearly income of $35,000, you’ll need to have invested $350,000 by the time you ease out of working in order to support your lifestyle.
Basically, then, you can add another zero to whatever you currently earn to determine a ballpark figure of how much you will need to have by the time you ease out of working so that you can maintain your present cash ﬂow.
Of course, inflation changes that canvas. You won’t know what the rate of inflation will be at the time you decide to stop working. The latest annual inflation rate for the United States is 2.1% through the 12 months ended June 2014. The most recent decade (2000-2009) changed from 2.57% to 2.56%.. A moderate inflation rate, like the one we’ve experienced over the past decade, will increase the amount of savings you will need by a greater or lesser extent, depending on how far into the future you plan to live on the cash ﬂow from your investments.
Figure Your Rate of Return
There are rates of return for every asset class, stocks, bonds, real estate and many more. The first place to start is to know what the rate of return has been historically for you to calculate your investment potential. No worries here, we’ll talk more about ‘asset classes’ later. For now, for example to know that the stock market (which is generally described as the S&P 500), has grown by about 10% over the ten year period between January 1, 2005 and December 31, 2014 (S&P returns by Robert Shiller and Yahoo Finance).
Now, that $600,000 in income that we just discussed might seem like a whole lot of money to you to create without working daily yourself.
Rule of 72 Definition
But let me tell you about a second jewel for your financial treasure chest. This second gem is called the “Rule of 72 formula.” The Rule of 72 is a simple mathematical calculation to help you understand the growth of your money. Here’s how it works. Take whatever rate of return you expect to earn, and divide the number 72 by it to determine how many years it will take for your money to double at that rate.
For example, let’s say the rate of return you use is 10 percent, the average rate of return in the stock market. Divide 72 by 10. This equals 7.2. That means it will take seven plus years for your money to double at that rate. Why use the stock market? Because it is an example of an investment that most people know about. In 1995—an exceptional year for the stock market—the market gave returns of 36 percent to investors, which means that at that rate, if you got this return in the stock market, your money would double in two years. A savings account at a bank currently averages 3 percent, and it would therefore take twenty-four years for your money to double. Underlying the Rule of 72, then, is the principle that a fair rate of return makes a significant difference in the growth of your money.
According to the Rule of 72, if you’re forty years old, money you’ve invested now at an expected growth rate of 12 percent can double four times by the time you reach sixty-four. Thus, if you have already invested, for example, $40,000, it can double four times to $640,000 in twenty-four years. (It would grow to $80,000 at age forty-six, $160,000 at age fifty-two, $320,000 at age fifty-eight, and $640,000 at age sixty-four.) So, as you can see, if your investments are working for you, your money naturally grows so you can reach the $600,000 we talked about.
The Rule of 72 is a handy tool for forecasting the growth of your money and determining its future potential for you. And it exemplifies the power money can have for women. Who would want to miss the opportunity to put this resource to work in her life?
Let’s take a look at Linette Atwood, my New York marketing friend who’s struggling with a divorce, and find out how she finally used the principles of good money growth.
We met for lunch one day while I was in New York on business. I hadn’t seen Linette since my visit to the Ranch. Her divorce was proceeding, and her lawyer had sorted through some of the financial muck that had so clouded her perceptions months before. In her professional guise, Linette looked much more in control, self-assured, and competent. You would never have guessed that this woman hadn’t been in charge of her own financial life all along.
Over lunch, Linette told me that a “little voice” had been nudging her for a while to do something, but she’d been ignoring it.
Remove Your Illusion
“You know, she told me, I’m working on an account for a woman’s magazine right now. I just might talk to the editor about doing a column about the illusions women create about their financial lives. Maybe that will get more people talking about it,” Linette said. “I never talked about my money to anyone, ever. Frankly, with my friends, the subject never came up. But now that I’m in a crisis, it’s on my mind all the time and I feel a little freer about opening up to the people closest to me.”
Linette told me a little more about her life. She originally had gone to work so that she could have spending power, and she looked great in the latest fashions. But she hadn’t moved on to the next priority—long-term financial growth. Now, with her life turned upside down by divorce, she needed to get her house in order. In particular, she needed to start saving and investing so that her daughter would be able to attend college in a few years.
Linette had stopped at a certain point in her maturity—taking control of your financial life is a maturation process. Her spending was not necessarily in line with her long-term financial objectives. How many clothes and stuff do we really need? Linette is seeing that, like some women, she’s devoted herself to beautifying her body and her home without nurturing her soul. The outside looks like a million bucks; the inside is a house of cards. Developing a financial life, however, is about a state of mind. Being financially solvent isn’t just about having money, but about having the temperament for managing your money. Please write that one down and put it up on your bathroom mirror!
“You do have options, Linette,” I volunteered.
“You can keep your present job, make the same salary, and dramatically cut your expenses, or you can creatively add to your income—either way, you’ll increase your bottom line,” I said.
I showed her the Earnings Outlook chart below. This chart shows, based on what she earns today, how much money goes through her hands.
Monthly Income 10 Years 20 Years 30 Years 40 Years
“I’ll leave you with this thought: When you were married, you spent more than $10,000 a year on clothes, jewelry, vacations, and extras for your daughter, Kimberly, right?” Linette nodded. “Well, if you cut out most of that and save $7,500 to invest each year, you can grow that money so that you’ll have an annual income of $100,000—less taxes and inflation adjustments—by the time you’re age sixty-five. Just remember that little ‘jewel’ I’m always talking about: Spend less than you earn, invest the difference, then reinvest the returns.”
Linette promised to give some thought to what I had said. If she takes control of her financial life by spending less each year and investing the difference, she will be able to live comfortably in the twenty-first century. She will enhance her life by approaching it this way. It’s all a matter of learning how to selectively spend money. By reevaluating her priorities, she can set new goals for her money and be more self-assured in terms of how she spends. By engaging in the financial part of her Wheel of Life, she will give herself breathing room to work on her family problems and to bring the spiritual and mental parts of her Wheel into balance, too. She’ll have peace of mind, knowing that she and her daughter will be in good shape for life. The ability of invested money to grow is the key to achieving this goal.
Are you convinced that making your money work for you, starting today, can make all the difference in your future? If so, it’s time to take a closer look at your money-building options.