Happy New Year! 2017 is certainly gearing up to be interesting. Last November we elected a new president and if one thing is certain, the future is totally unpredictable. As an investor you should never lose site of this simple yet very important fact. As I observed the coverage of the presidential election many fears were brought up on what the election of a President Trump would do to the financial markets and our economy. This was also true of what was said and reported back in late June right before the Brexit vote. As Britain was deciding whether or not to leave the European Union, the uncertainty was met with an onslaught of strong opinions regarding the impact. In both of these cases, by in large the experts got it wrong.
When I listened and watched these experts, I am reminded of a saying my father used “Don’t believe anything you hear, and only half of what you see.” This saying is as true today as it was back in the days when I was just starting out. This is equally true when it comes to making investments and decisions that can affect the outcome of your investments. Since the overall objective of most investment programs is to make money, we should take a few moments and remind ourselves on how we do that. Before making any investment decision, one of the key elements you face is working out the real rate of return on your investment.
Compound interest is critical to investment growth. Whether your financial portfolio consists solely of a deposit account at your local bank or a series of highly leveraged investments, your rate of return is dramatically improved by the compounding factor.
With simple interest, interest is paid just on the principal. With compound interest, the return that you receive on your initial investment is automatically reinvested. In other words, you receive interest on the interest.
But just how quickly does your money grow?
The easiest way to work that out is by using what's known as the “Rule of 72.” Quite simply, the “Rule of 72” enables you to determine how long it will take for the money you've invested on a compound interest basis to double. You divide 72 by the interest rate to get the answer.
For example, if you invest $10,000 at 10 percent compound interest, then the “Rule of 72” states that in 7.2 years you will have $20,000. You divide 72 by 10 percent to get the time it takes for your money to double. The “Rule of 72” is a rule of thumb that gives approximate results. It is most accurate for hypothetical rates between 5 and 20 percent.
While compound interest is a great ally to an investor, inflation is one of the greatest enemies. The “Rule of 72” can also highlight the damage that inflation can do to your money. Inflation simply means that over time as cost of living increases, your investments need to grow in order to keep pace with the increasing cost of living expenses.
Let’s say you decide not to invest your $10,000 but hide it under your mattress instead. Assuming an inflation rate of 4.5 percent, in 16 years your $10,000 will have lost half of its value.
The real rate of return is the key to how quickly the value of your investment will grow. If you are receiving 10 percent interest on an investment but inflation is running at 4 percent, then your real rate of return is 6 percent. In such a scenario, it will take your money 12 years to double in value.
The “Rule of 72” is a quick and easy way to determine the value of compound interest over time. By taking the real rate of return into consideration (nominal interest less inflation), you can see how soon a particular investment will double the value of your money.
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The Rule of 72 is a mathematical concept, and the hypothetical return illustrated is not representative of a specific investment. Also note that the principal and yield of securities will fluctuate with changes in market conditions so that the shares, when sold, may be worth more or less than their original cost. The Rule of 72 does not include adjustments for income or taxation. The Rule of 72 is intended to be a planning tool you can use while a great resource it does have its limits. For instance it only assumes that interest is compounded annually; therefore, since not all investments are measured the same way, actual results will vary.
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James De La Torre has conducted federal benefit and financial planning seminars in all of the country. He is a key note speaker at federal conferences and works with federal professional organizations on ways to improve the communication of federal benefits to their membership. Jim has appeared as a guest on “Fed Talk” on the Federal News Radio network, discussing the gaps in federal benefits and the financial impacts employees face. Jim holds a Charter Retirement Planning Counselor’s (CRPC) designation from the College or Financial Planning and is a member of the Financial Planning Association. Please direct questions or comments directly to James at [email protected].
When I listened and watched these experts, I am reminded of a saying my father used “Don’t believe anything you hear, and only half of what you see.” This saying is as true today as it was back in the days when I was just starting out. This is equally true when it comes to making investments and decisions that can affect the outcome of your investments. Since the overall objective of most investment programs is to make money, we should take a few moments and remind ourselves on how we do that. Before making any investment decision, one of the key elements you face is working out the real rate of return on your investment.
Compound interest is critical to investment growth. Whether your financial portfolio consists solely of a deposit account at your local bank or a series of highly leveraged investments, your rate of return is dramatically improved by the compounding factor.
With simple interest, interest is paid just on the principal. With compound interest, the return that you receive on your initial investment is automatically reinvested. In other words, you receive interest on the interest.
But just how quickly does your money grow?
The easiest way to work that out is by using what's known as the “Rule of 72.” Quite simply, the “Rule of 72” enables you to determine how long it will take for the money you've invested on a compound interest basis to double. You divide 72 by the interest rate to get the answer.
For example, if you invest $10,000 at 10 percent compound interest, then the “Rule of 72” states that in 7.2 years you will have $20,000. You divide 72 by 10 percent to get the time it takes for your money to double. The “Rule of 72” is a rule of thumb that gives approximate results. It is most accurate for hypothetical rates between 5 and 20 percent.
While compound interest is a great ally to an investor, inflation is one of the greatest enemies. The “Rule of 72” can also highlight the damage that inflation can do to your money. Inflation simply means that over time as cost of living increases, your investments need to grow in order to keep pace with the increasing cost of living expenses.
Let’s say you decide not to invest your $10,000 but hide it under your mattress instead. Assuming an inflation rate of 4.5 percent, in 16 years your $10,000 will have lost half of its value.
The real rate of return is the key to how quickly the value of your investment will grow. If you are receiving 10 percent interest on an investment but inflation is running at 4 percent, then your real rate of return is 6 percent. In such a scenario, it will take your money 12 years to double in value.
The “Rule of 72” is a quick and easy way to determine the value of compound interest over time. By taking the real rate of return into consideration (nominal interest less inflation), you can see how soon a particular investment will double the value of your money.
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
The Rule of 72 is a mathematical concept, and the hypothetical return illustrated is not representative of a specific investment. Also note that the principal and yield of securities will fluctuate with changes in market conditions so that the shares, when sold, may be worth more or less than their original cost. The Rule of 72 does not include adjustments for income or taxation. The Rule of 72 is intended to be a planning tool you can use while a great resource it does have its limits. For instance it only assumes that interest is compounded annually; therefore, since not all investments are measured the same way, actual results will vary.
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
James De La Torre has conducted federal benefit and financial planning seminars in all of the country. He is a key note speaker at federal conferences and works with federal professional organizations on ways to improve the communication of federal benefits to their membership. Jim has appeared as a guest on “Fed Talk” on the Federal News Radio network, discussing the gaps in federal benefits and the financial impacts employees face. Jim holds a Charter Retirement Planning Counselor’s (CRPC) designation from the College or Financial Planning and is a member of the Financial Planning Association. Please direct questions or comments directly to James at [email protected].