This is the third lesson regarding investments. And here we are going to learn something what can be practically used immediately. Plus, 3 rules we are going to talk about – they belong to a “gentlemen set” of any more or less knowledgeable investor.
Rule of 72
I learnt the Rule of 72 many years ago from the books of a prominent German couch, motivational speaker and entrepreneur Bodo Schaefer.
Let’s illustrate this rule at the example below:
You want to deposit $100 to bank. Interest rate is 6%. How long does it take to double the investment? Assuming, of course, that all interest generated on monthly basis is re-invested (stays in the same deposit account and generates more interest – aka compounding interest).
Rule of 72 will help us to answer this question quite precisely and very quickly. The timespan to double the investment equals 72 divided by the interest rate:
Years to double = 72 / Interest Rate.
In our case it will be 12 years (72 / 6 = 12).
Some more caveats on this rule:
- It is also know as Formula of 72;
- It is an important condition to have a monthly compounding. The rule will not work if payments are less frequent;
- The same formula is applicable if you answering the questions how long will it take for the money to loose half of its value (buying power) if you know the inflation rate.
Problem #1: Use either an excel sheet or your bank savings account statement to see that the Rule of 72 works.
Problem #2: When you open up a savings account, you are told that it will pay 0.5% interest annually. How many generations of you family it will take to notice that your initial deposit doubled? Provided, of course, that you will not add more money later, that this account will not be amended by bank and that one generation is 30 years.
Problem #3: Provided that an inflation rate is 2%, how long it will take to for your money to loose 3/4 of its current buying power?
Rule of 150
Another great rule from the same author – Rule of 150:
In order to cover your monthly expenses you need to invest 150 times your monthly expenses at 8%.
Problem #4: Apply the rule of 150 to your own (or your household’s) expenses.
This rule is not very official and it refers to a very simplistic model of how banking system works. Later when we are going to cover the banking system, we will discuss what it has “under the hood” in more details. 3-6-3 Rule states:
A banker would borrow money, giving 3% interest on depositors’ accounts, lend the money at 6% interest and then at 3pm the banker should be playing golf (constants and time may vary, but 3-6-3 is classic).
This means: the only form of business of a bank is lending out money at a higher rate than the rate paid out to its depositors.
Answers to problems will be added later on, so in one of the upcoming articles I will give an update on that.