The Rule of 72
By David Nelson, CFA CMT
Wall Street loves complex theories of why an asset class will outperform or head south. We tear apart income statements, balance sheets and parse every word from the FOMC. We run thousands of back tests on multi-factor quantitative models diving through virtually every data point that relates to a company, commodity, fixed income instrument or real estate. Real time satellite imagery, super computers not to mention the thousands of engineers using fast programing languages like Python have all been tapped to determine what an asset class is going to do in the next minute, hour, day, month and year. The point is we will do almost anything to gain an edge.
Sometimes it just isn’t that complicated. In a recent meeting one of our advisors Rich Roscelli reminded me of the Rule of 72. It made me smile and took me back to my early days at Merrill Lynch when I first heard of the term. It’s simple. Just divide the number 72 by the annual return of an asset class and you’ll come up with the number of years it takes to double your money.
i.e. 72 divided by a 10% return equals 7.2 years to double your money. Yes, the logarithmic calculation is a little more complicated, but you get the idea.
It was rumored for years that Albert Einstein was the author of the quote “Compound interest is the 8th Wonder of the World” and came up with the Rule of 72 as a quick formula but after digging through countless articles and Google searches it seems this is little more than folklore. However, there does appear to be conclusive proof that he did say “the hardest thing to understand is income taxes” but I’ll leave that for my next article.
The world holds approximately $27 Trillion in U.S. debt so it is a good place to start our analysis. Let’s see what kind of return you get and how long it would take to double your money.
A 30-year piece of paper yields 1.64% and would take you just shy of 44 years to double your investment. How about the benchmark 10-year. Whoops! At just 0.89% would take almost 81 years. It gets worse. 5-year treasuries would take 180 years and if you rolled 1-year T-Bills at 12 basis points it would take a whopping 600 years to double your money.
Corporates offer more. The current BBB investment grade curve shows a 10-year gets almost 2.8%. Wow our rule of 72 says you can double funds in just 26 years.
Ok, let’s stretch a little. How about junk? High Yield funds offer more yield than treasuries and high-quality corporates but in the long run have the same risk profile as stocks. One look at the pandemic drawdown earlier this year shows the better than 5% yield did not provide that much protection in the face of a full-blown panic. Let us assume for the moment that you will earn the current 5% yield. Our rule of 72 says it will take 14 years to double your investment. Certainly, better than corporates and a home run compared to treasuries.
What about Gold?
In the last 20 years Gold has been a fantastic vehicle for wealth creation. It does not have a yield, but you would have doubled your money 6 times over. Of course, today’s price is just under where it stood in 2011. Nine years is a long time go without a return and with no dividend or interest rate payment to help pay the bills it’s for hard core believers of the yellow metal.
In this context suddenly stocks don’t look all that expensive and while not the only game in town certainly in position to see a lot of fund flows as step by step America goes back to work. As I said last week the vaccine is a game changer and estimate revisions the Holy Grail of securities analysis will continue to move higher for most industries.
Think of it this way. Assets compete for your dollars just like everything else. It is a combination of total return and the risks you took along the way. In the last 40 years the S&P 500 has averaged 8.5% annually since November 1980. Our rule of 72 puts stocks at an attractive 8.4 years to double your money and that’s not counting dividends. Add the 1.6% available today and the picture gets a whole lot brighter.
The above doesn’t suggest that the next 40 years will look anything like the last 40. We have gigantic deficit, a Fed balance sheet measured in $Trillions and every corner of the world is still a geopolitically nightmare. Add the fact we live in a nation divided stock returns could easily fall below that ambitious outlook.
Until there is competition for your investment dollars stocks still look like the better asset class.