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The Rule of 72: Why it might be useful to consider when investing in Stocks
Investing in stocks can be a daunting task, especially for beginners. With so many different strategies and techniques available, it’s easy to get lost in the sea of information about what stocks to buy, what strategies to use and what is most important to look for when undertaking due diligence.
However, there is one simple rule that every investor should know, even if they don’t follow it – the rule of 72.
What is the Rule of 72?
The rule of 72 is a quick and easy way to estimate the number of years it will take for an investment to double in value. It is based on the principle of compound interest, which states that when you earn interest on your initial investment, you also earn interest on the interest earned etc.
How Does it Work?
To use the rule of 72, simply divide the number 72 by the annual rate of return on your investment. The result will give you an estimate of the number of years it will take for your investment to double in value.
For example, if you have an investment with an annual return of 10%, it would take approximately 7.2 years (72/10) for your initial investment to double in value. If you have an investment with an annual return of 5%, it would take 14.4 years to double in value – at least in theory.
Why is the Rule of 72 Important?
The rule of 72 can be a handy tool for investors as it helps them make quick and dirty estimates about their investments. It also emphasizes the power of compounding, which is essential for long-term investing success. It tells investors how long they (might) need to wait before getting the returns they are seeking and perhaps avoiding investments they don’t have the patience to stick around for.
It can be applied to any type of investment – ASX stocks, international stocks, bonds, mutual funds…even real estate. It is a simple and universal concept that can help investors make informed decisions about their portfolio.
Limitations of the Rule of 72
While the rule of 72 can be a useful tool for estimating investment growth, it is important to note that it is not a precise calculation. The rule assumes a constant annual return rate, which may not always be the case. Factors both within and out of a company’s control can tear ambitions to shreds whether technological advances, increased market competition, regulatory problems or the departure of key personnel.
Additionally, it does not take into account factors such as fees and taxes (such as income tax, capital gains tax and stamp duty), which can significantly impact investment growth and returns. Therefore, it should only be used as a rough estimate and not as a substitute for thorough financial planning or due diligence on a company (particularly the risks of it succumbing to the risks listed above).
The rule of 72 is a simple yet powerful concept that can help investors make informed decisions about their investments. By understanding how this rule works, investors can better manage their portfolio and achieve long-term financial success.
However, it is important to remember that the rule of 72 is just a rough estimate and should not be used as the sole basis for investment decisions. It is always advisable to consult with a financial advisor before making any significant changes to your investment strategy. And even before seeking financial advise, it is not wise to change your whole strategy just to try and follow one specific rule.
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