The Rule of 72

(The following article has been printed -- well, nowhere. But it's been on my hard drive for a while, and since blogs need content, it has now found a new home. Hope you enjoy, and perhaps even come away a bit more enlightened on what I consider an important subject.)

The Rule of 72

 

I’d like to introduce you to a friend of mine. Unlike those special ‘friends’ who literally seethe with resentment should you be so fortunate as to enjoy a bit of good fortune, this friend takes enormous pleasure in your success. The more successful you are, the wider his smile grows, until he’s grinning like a drunken Jack O’ Lantern on All Hallow’s Eve.

And what is this friend’s name? Most folks know him as “The Rule of 72”. He is a wealth-builder, and his goal is to make even the most casual of his acquaintances as rich as Midas. In exchange, he only asks for three things: (1) a bit of cash, (2) fiscal discipline, and (3) time.

The Rule of 72 is a formula, a simple one, really. The trick is to solve for x:

x = 72/g

And what are the variables?

g = Growth rate, a whole number normally expressed as a percentage.
x = The number of years it takes to double a given sum of money.

It works like this:

Suppose you have an (empty) savings account which pays you 3% interest. You have $1000 which has been burning a hole under your mattress. The smell of singed feathers is starting to keep you up at night, so you decide to invest this money in your local savings account. Being a curious sort, you find yourself wondering how long it would take to turn that $1000 into $2000. So you pay your friend a visit at his place of residence, the local calculator. Here is what he tells you:

x = 72/3
x = 24

So turning an investment of cash, $1000, into $2000 will require an additional investment of time, equal to twenty-four years.

If your thoughts in any way resemble mine the first time I solved for x, they are probably not printable in a family-friendly blog like this. At best you’re likely thinking, “That’s pretty unimpressive.”

Not only is that timeline unimpressive, it’s also costing you money, because we have not yet considered inflation. According to inflationdata.com, the average yearly rate of inflation from 1914 to 2011 has been 3.24%.

In short, in the time it will take you to earn that $2000, not only will you have lost any gains your interest rate might otherwise have earned for you, you will have lost principal as well, spent most likely on frivolous luxuries like food, shelter, lotto tickets (also known as ‘a tax on people who are bad at math’), etc.

So what other options are there?

One can get rich by earning obscene amounts of money as a franchise sports star, a box office drawing celebrity, or (one of the most common ways during this century’s first decade) from bonuses earned as the CEO of a financial company with mediocre to downright poor results (I’m guessing they were paid for having good hair). The downside here is that sports stars accumulate injuries, movie stars lose their looks, and Wall Street CEO’s eventually drag their companies down so far that they are allowed to retire with golden parachutes in the seven to eight figure range . . .

Okay, bad example. But for those of us not fortunate enough to fit any of the above, not lucky enough to pick the right numbers for that lottery ticket, or who lack the foresight of being related to soon-to-be deceased relatives who are both fabulously wealthy and poor judges of character, we must consult our financial GPS and take a different route. And here is where our friend, who never learned not to pick up seedy hitchhikers such as ourselves, steps in.

There are two basic investment vehicles our friend offers, stocks and bonds. Both are legitimate investments, but for the purposes of our example, we’re going to stick with stocks, which over time tend to outperform bonds.

Since the beginning of the 20th century till now, the American stock market has experienced an overall growth rate with estimates ranging from 8-10%. We’re going to split the difference here and call it 9%. If we plug this number into our friend’s slot (a disturbing image, but only to the already filthy minded), here is what we get:

x = 72/9
x = 8

This means that were we to invest $1000 into a stock fund mirroring the overall stock market over a twenty-four year period, it would grow as follows:

8 Years = $2000
16 Years = $4000
24 Years = $8000

Not too bad. Even with inflation taking a bite, we will still end up coming out ahead. And while past performance is no guarantee of future returns, it’s a better option than storing your Benjamins in Madoff’s Savings and Loan.

But can one invest in the American stock market as a whole? Yes. There are index funds based on the Wilshire 5000 index, a market-capitalization-weighted index of the market value of all stocks actively traded in the US.

A better way, and with less risk, would be to invest in a very traditional balance of stocks and bonds, 60% stocks and 40% bonds, and then utilize rebalancing.

Que?

Okay, here’s the theory behind rebalancing. It’s actually a variation of a common (and snide) Wall Street cliche about how to make money in the market: “Buy low, sell high.”

It works like this: at the beginning of the year, your investments are divided 60/40 into a Wilshire 5000 Index Fund and a broad-based Intermediate Bond Fund. At the end of the year, your averages will be a bit different, maybe 64/36, or possibly 57/43, due to either the overall stock or bond markets outperforming the other. This is the reason for the split in the first place, the theory being that in a given time span stocks will either outperform bonds, or vice versa. So one takes the excess from the side above the average and transfers it to the lower. The idea is that, in the short term, whatever goes up must come down, so by transferring gains from the higher of the two, those gains are protected from the inevitable downturn. Buy low, sell high.

An even better distribution was published by an issue of Consumer Digest’s Money newsletter. It breaks down as follows:

S&P 500 Index Fund:  20%
Small Cap Index Fund:  20%
Global Market Index Fund: 20%
Intermediate Bond Fund:  30%
Money Market Fund:  10%

According to the aforementioned newsletter, this distribution -- rebalanced annually -- does a bit better than the previous one.

So, a better option. But can one do still better?

One gentleman thinks so. His name is Joel Greenblatt. He is the author of a small volume called The Little Book That Beats the Market, a NY Times best-seller. To summarize, this work explains – in simple, easy to understand language – how to invest in such a way as to generate returns of approximately 30.8%.

I will not go into Mr. Greenblatt’s formula (which he explains in his book), except to offer this one-sentence summary of how it works:  “The Magic Formula strategy is a long-term investment strategy designed to help investors buy a group of above-average companies but only when they are available at below-average prices.” Anyone who wishes to know more is encouraged to read his informative – and frequently humorous -- book.

There will always be naysayers, and I have not as of yet attempted to use Mr. Greenblatt’s formula (preferring my own more proactive method of stock-picking at this time). However, it would at best be problematic explaining my own strategies, while Mr. Greenblatt’s method is quite simple, requires a minimum of time and effort, does not require extensive knowledge of investing, and can be done by anyone with a computer and an Internet connection. And if you are wondering why everyone is not out duplicating Mr. Greenblatt’s strategy, he includes an explanation for that as well.

For the sake of illustration, let us assume not only that Mr. Greenblatt’s method works, but that it does not even work as well as the theoretical average. Let us assume that, due to inevitable flies in the ointment, the average return over a 24 year period is only 24%, then solve for x:

x = 72/24
x = 3

Now let’s do the math:

3  Years  = $2000
6  Years  = $4000
9  Years  = $8000
12 Years  = $16,000
15 Years  = $32,000
18 Years  = $64,000
21 Years  = $108,000
24 Years  = $216,000

Better than $2000, to be sure. And it even provides a cushion against that pesky inflation.

But (and this by now should sound familiar), can we do even better?

In the US there exists something called a Roth IRA. This is a retirement account most financial institutions offer. It has a maximum contribution limit of $5000 ($6000 for anyone over the age of 55). Unlike its cousin, the deferred IRA, there are no tax benefits for contributions made to it. However, any earnings made on contributions and then withdrawn during one’s retirement are not subject to taxes.

So if instead of $1000 in a savings account, we instead put $5000 into a Roth IRA and followed Mr. Greenblatt’s formula, what kind of returns might we expect?

3  Years = $10,000
6  Years = $20,000
9  Years = $40,000
12 Years = $80,000
15 Years = $160,000
18 Years = $320,000
21 Years = $640,000
24 Years = $1,280,000

And this with no taxes, as well as no further contributions beyond the initial $5000.

There is a biography of the famed investor, Warren Buffett, called ‘Snowball’. The reason it is called this is because of the snowball effect, how a small handheld snowball rolling down a mountainside can grow to enormous size by the time it reaches bottom. A similar principal is at work here. Or, as Albert Einstein once supposedly said, “The greatest known power in the universe is compound interest.”

So now, of course, anyone reading this will go out, make their fortunes, and the world in 24 years will be so full of millionaires you won’t be able to shop the express line at Walmart without tripping over half a dozen, right?

Nope. Not a chance.

Why?

At the beginning of this diatribe, I said there were three things required to build wealth. One was time. Well, most folks have time; even older ones like myself. Twenty-four years isn’t all that long, unless one is elderly already. So we’ll give that one a pass. Where almost everyone who reads this will get tripped up will be by the other two, which are: (1) A bit of money and (2) fiscal discipline.

How is that? After all, with huge gains such a reasonable possibility, how could one not put aside a ‘bit’ of money? Well, primarily because of (2).

Most people spend all of their money to improve their quality of life. And once that level of spending has been established, it is very difficult to change their fiscal habits. Theoretically it shouldn’t be hard, the optimist might suggest. Everyone knows someone who lives at, say, 90% of what one’s self earns, so it’s doable. Just live like that person, the optimist says, and invest the remaining 10% as has been illustrated above. Right?

Wrong. The sad truth is that many people would rather spend money buying lottery tickets than putting that same amount of money into an account set up to achieve the amount of returns described above, because those returns are contingent upon one thing: delayed gratification.

Well, someone might say to me, if you’re such a pessimist, then why bother taking all of this time making your case?

Truth? I’m not sure. But maybe, like the famous glass, I’m only half a pessimist.