What is so great about the number 72?
Let me explain what makes 72 the answer
Using an example, if you invested $10,000 that earned you 10% per annum, how much would that investment be worth after 7 years ?
You may expect the answer to be $17,000, as 10% return on $10,000 for each of 7 years would be $7,000. However, the answer is actually $19,487.17 to be exact. This is because your investment earns interest on the interest each year, in jargon speak, compound interest.
What this means is, at the end of the first year, you would have $10,000 plus $1,000 of return, and at the end of the second year, you would have 10% on this $11,000 (rather than just on the initial $10,000). Each year this happens, the greater the effect on your long-term returns. Of course, if you spend the 10% return each year, you will still have $10,000 at the end of 7 years.
What about the number 72? How does that fit in?
The number 72 allows you to quickly and easily work out how much investments may be worth over time. It works like this - if you divide 72 by the interest rate, this will estimate how long it takes to double your investment.
Using the example above, 72 divided by 10% equals 7.2. So your initial investment doubles from $10,000 to $20,000 after 7.2 years. This sounds pretty good, but it gets better as this doubling effect continues. After 14.4 years, you would have $40,000, then $80,000 after 21.5 years, $160,000 after 28.8 years, and $320,000 after 36 years. So in this example, your $10,000 investment would increase to $360,000 after 36 years. Pretty cool, isn't it?
Another great way to use this method is to work out the effect of inflation on your investments.
Let's say you have 24 years left before you retire, and you think you will need $1 million in today's money to retire on. If you had one million dollars and put it under your mattress for "safekeeping", that one million dollars would buy more today than it would in 24 years' time because of the impact of inflation.
If we estimate that inflation is 3% per annum, then 72 divided by 3% gives us an answer of 24 years. This means that having $1 million today is the same as having $2 million in 24 years' time, because of the impact of inflation.
Considering inflation then, the $360,000 after 36 years in the first example is actually closer to $125,000 in today's dollars. This is still pretty good, but does prove that the earlier you start putting savings away, the more time The Answer 72 has to work its' magic! Compounding is a wonderful thing. Give it time to work for you.
John Clarke - Clarke McEwan Accountants and Business Advisors.