Many of you have likely heard of the adage, “the Rule of 72.”
It’s used frequently in the investing world because it provides a simple way for calculating how long it will take for an investment to double in value. You simply take the assumed annual rate of return (typically 10% for the historical S&P 500 return) and divide that number into 72.
So 72 divided by 10 equals 7.2 years for the investment to double.
This works for any annual rate of return assumption:
72/13 = 5.5 years
72/7 = 10.3 years
72/5 = 14.4 yers
This is very straightforward if you think of it in terms of compound interest. Each year the interest is paid, and then interest is paid on previous interest, therefore compounding and increasing exponentially over time.
However, real life investment returns tend to me more variable. Take for example the S&P 500 price return (excluding dividend reinvestment) year-by-year for the previous 10 years (including 2024 year-to-date):
What we see here are the following annual return numbers:
2015: -0.73%
2016: 9.54%
2017: 19.42%
2018: -6.24%
2019: 28.88%
2020: 16.26%
2021: 26.89%
2022: -19.44%
2023: 24.23%
2024: 10.42%
Annualized Return:
10.92%
So holding the S&P 500 over the previous 10 years would have resulted in a return where the investment doubles in value in 6.5 years. This is great, but there are other factors to consider, namely taxes and inflation! Taxes can be mitigated in many different ways through asset location and proper use of tax-efficient vehicles like ETFs and individual stocks. But inflation, unfortunately, is something outside of our control.
Inflation Rule of 72
All else held equal, inflation can be defined as purchasing power decreasing over time as more and more dollars chase the same number of goods and services. The term “inflation” refers to the money supply increasing, like a balloon pumped up with more air or a bath tub being filled with additional water. As a result, supply/demand dynamics kick in, prices go up and more dollars are required to obtain the same number of goods and services.
If you want to see how long it will take for your purchasing power to be cut in half by inflation we can use the same Rule of 72 formula:
72/5 = 14.4 years
72/3.5 = 20 years
72/2 = 36 years
If inflation were to be constant at 5%, our purchasing power would be cut in half every 14.4 years. You can see why all of the Central Banks across the globe have a 2% inflation target and why it is so important for every dollar to be working in your favor with a rate of return in excess of inflation!
This is one of the many reasons why we place such a heavy emphasis on smart financial planning. As many of you know, we stress test our financial plans for various risk factors using Monte Carlo analysis. What we are commonly finding are results similar to these shown below:
Higher inflation and higher taxes are flagging for many folks as we continue to maintain higher prices post-pandemic and we approach the sunset of the Tax Cuts and Jobs Act (TCJA) at the end of 2025.
These particular Monte Carlo results assume inflation to be held at 5% going forward, which thankfully, is unlikely. However, it does not undercut the risk of inflation and what we can do to fight it.
We maintain that the best way to fight inflation is to be invested in good long-term holdings like stocks and real estate. If prices are going up due to inflation of the money supply, then it behooves all of us to own shares of those companies that will obtain higher revenue as a result. Debt instruments like bonds, private credit, and structured notes are also very effective here and provide additional benefits through lower correlation and volatility.
Our portfolio allocations remain structured to fight inflation by owning the best companies in the world and also be tax efficient through smart asset location and use of efficient investment wrappers.
We thank you all for your continued trust and will strive to remain diligent in our mission to provide the best financial planning and investments to each of you, the most productive people on the planet.
References:
S&P 500 historical annual returns. MacroTrends. (n.d.). https://www.macrotrends.net/2526/sp-500-historical-annual-returns