Tuesday, June 30, 2009

Rule of 72

First off, the "rule" of "72" is not a rule in the sense of "rules and regulations." It is simply a quick rule-of-thumb method of calculating future value. If you take a rate of return and divide it into 72, the answer tells you how many years it will take for your money to double. At 9%? Eight years. 72 / 9 = 8. Or, you can take the number of years in which you need the money to double and divide that into 72. The answer here gives you the required rate of return. If you want your money to double in 4 years--good luck. 72 / 4 = 18, and you aren't getting a compouned 18% return anywhere legal.
So, the Series 65/66 could easily throw a smart-aleck question like this one at you, and I'd like you to be ready for it, like a big-league hitter smiling as a rookie pitcher tries to jam him up high and inside. Ready? Let's take a look anyway:

Melody's goal is to invest $2,000 today into an aggressive growth mutual fund. At the end of her 10-year time horizon, Melody expects the account to be worth roughly $8,000. The approximate compounded rate of return required is:
A. 7.2%
B. 10.3%
C. 14.4%
D. 27.4%

EXPLANATION: using the "rule of 72" you immediately hit a speed bump when you realize that melody doesn't just want the money to double--she wants it to double twice in 10 years. Typical Series 65/66 brushback pitch. Oh well. 7.2% would be the answer if she wanted the money to double once in 10 years. I guess the rate needs to be twice as high, right? 14.4% approximately.

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