The concept of compounding or discounting

Jul 24, 2017 | Tony Byrne's View

Ever struggled to get your head around the concept of compounding or discounting? For many people maths is a challenging subject but for us as wealth managers it is of course our bread and butter. So how about a simple rule for working out how long it takes to double your money? Welcome to the Rule of 72!

Basically you start off with the original amount of your investment, let’s call it ¬£100K.¬†You then make an assumption about the level of annual return you expect to make.¬†For simplicity’s sake let’s use 10% which happens to be the average annual return our Wealth Investment Strategy has achieved over the last 21 years for a medium risk investor.¬†Well it has in fact been 9.8% but I’ve rounded it up to make the maths simpler!¬†You then simply divide 72 by 10% and hey presto the result is 7.2 years to double your money which means your investment has increased in value from ¬£100K to ¬£200K!¬†So it is a rule to find out how long it takes to double your money.¬†Simple eh?

The Rule of 72 should in fact be the Rule of 69 because 69 gives a more accurate result. However the number 69 is not appropriate for 2 main reasons. One obvious reason I am sure readers are aware of so I do not need to explain it any further! The other reason is because 69 is a notoriously difficult figure to divide into and get a round number result. As it is only a rule of thumb, 72 is good enough.

Where this stuff gets really exciting is when you look ahead a further 7.2 years or a further 14.4 years by which time your investment will have increased in value by a staggering 700%!  There are of course rules for these scenarios known as the Rule of 144 and the Rule of 216.

Interestingly you can use the Rule of 72 to find out how long it takes for inflation to halve the value of your money too! At the time of writing inflation stands at 2.9%. Let’s call it 3%. So if you divide 72 by 3 the result is 24. In other words 24 years to halve the value of your money in real terms! It is scary how fast the purchasing power of your money falls when inflation rages. I remember inflation averaging in the teens throughout the seventies. Can you imagine that happening again in the UK? An inflation rate of say 12% a year would mean your money halving in value in real terms in just 6 years!

So what’s the best way to stave off the threat of growing inflation?¬†By investing in real assets such as property and shares of course.¬†And who should you approach for such investment advice?¬†Why Wealth And Tax Management of course!¬†Who else?

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