My take on the rule of 72
Posted by Don on September 19, 2009
The greatest thing to those looking to increase wealth is the beauty of compounding. The Rule of 72 is a quick calculation to figure out how long it will take to double your money at a given rate of return, or allow you to figure out what rate of return you need to double your money in a certain period. For example if I am earning a rate of 2% on savings it will take me 36 years to double my money with no additional deposits. If I would like to double my money in ten years I need to earn a return of 7.2%.
Obviously the best way to gain wealth is to stay out of debt, save, and invest. Investing is truly how wealth is earned, and the annual rate of return is what determines how quickly your wealth accumulates. Warren Buffet, arguably one of the greatest allocators of capital ever, has made the bulk of his returns by investing and purchasing companies at a price that allows him an exceptional rate of return. He has increased the book value of Berkshire Hathaway by an annual rate of 20.3% since 1965 thru December 2008. So for the last 43 years he has doubled his money roughly every 3.5 years.
The question you should ask yourself is what can I do with excess cash to increase my principal? Should I allow my funds to sit in the bank earning 1% or can I earn a better return? Look at some of the stocks that are available right now and the dividends they are paying. Kraft foods (KFT) 4.4%, Verizon Communications (VZ) 6.2%, McDonalds (MCD) 3.5%. These are stable companies that are providing a return greater than savings or US Treasury bonds right now. Now can the price go down, yes it can so there is risk which you do not have in savings, but their is also the opportunity that these companies continue growing an provide price appreciation in addtion to their dividend return.
One way I have tried to increase my return is by purchasing some higher yielding stocks such as some of the Canadian energy trusts or REITs. These items often provide dividends from cash flow and pay out a majority of their earnings.
I have a REIT I purchased in early 2008 whose price is down 28% , however it is currently paying a dividend of 22%. My total cost of my initial purchase was $1,500 which has decreased to a current value of $1,150. I have received dividends in the amount of $418 in that time, so as you can see that on a return basis I have earned $68 since Q1 2008. Now is this a better rate of return than a savings account during the same period? Acctually that $68 over 18 months is an annualized return of 3.02% which is better than a savings account. So while the S&P 500 was going down 20% my stock also went down 28% however, I was able to earn a total return of 3% with the dividends I received.
I could have earned an even greater return had I reinvested those dividends at a lower rate, however the point I am trying to make is that savings is for liquid funds for emergencies not building wealth. If you have money just sitting around, do some reading or research on a high dividend paying stocks, that will generate passive income in addition to a return from higher prices and you will be able to make your nest egg grow even faster.
Some good sites for dividend investing:
