The Broken Rule of 72
If you put your money in the right places, it can grow substantially over time, thanks to the power of compound interest. It could even double, while you don’t have to do a thing.
Economists have a formula called “the Rule of 72.” The Rule of 72 can tell you how long it will take, not only for the money you’re saving to double but also for prices to double—a valuable guide when assessing the possible impact of inflation on your investments.
Here’s how it works: To figure out how many years it will take for an investment to double, divide 72 by the rate of return you’re earning. Let’s say you have $500 earning 6-percent interest. Your money will double to $1,000 in twelve years because 72 divided by 6 equals 12. To calculate roughly how long it will take for prices to double, divide 72 by the annual inflation rate. Let’s say inflation is currently 3 percent. Then prices may double in 24 years because 72 divided by 3 equals 24.
I hate to break it to you sports fans, but this formula is unrealistic because it is based on assumptions that the economy will always be increasing.
It’s important that you learn how to increase your wealth in a down as well as an upmarket. Your money can double much faster than in 12 years because you’ll be earning a much higher rate of return than 6 percent. Thus, you’ll be beating inflation by a significantly wider margin.
Information Is Power
It’s time, however, to let you in on a secret. Let’s say the economy goes into a nosedive—as we have all seen the last couple of weeks. An economic depression is an emotional depression. People lose money, and they get depressed. But if you’re armed with financial knowledge, you increase your chances of riding out a depression. Indeed, you might even make money in a downturn. Here’s the secret: Sophisticated investors make more money in times of bust. They keep their emotions neutral and enter the market when everyone else is fleeing in panic. The financially intelligent buy when others are selling. Great opportunities are seen, not with your eyes, but with your mind.
Fortunately for you, we are now in the Information Age. For the first time in history, the 90/10 rule (10 percent of the investors making 90 percent of the money) need not apply. Information isn’t restricted the way land and resources were in the age of the feudal lords or the robber barons. It is now possible for more and more people to gain access to the world of wealth through information. That’s because information is power. Do you want to be one of the informed? More importantly, do you want to put your knowledge to work? Then have patience and read on. There’s still plenty to learn about accounting, taxes, and investing.
Make Money No Matter Which Way the Market is Going
Most professional investors know that in the real world, markets move in three basic directions.
- Markets move up, which is called a bull market.
- Markets move down, which is called a bear market.
- Markets move sideways, which is called a channeling market.
Since markets move in three different directions and most portfolios are filled with investments that do well only in up markets, that means that most portfolios of average investors will only do well in one out of three market directions.
Rich dad once told me, “Most of us have heard of Russian roulette. That is where a person takes a revolver with six chambers and puts one bullet in one of the chambers. They then spin the cylinder, put the gun to their head, and pull the trigger, hoping that the hammer lands on one of the five empty chambers. In other words, the odds are five to one in their favor. With most retirement plans loaded with mutual funds, a person is spinning a cylinder with only three chambers, and two out of three chambers are loaded.” In other words, your chances of losing are two out of three. Talk about risky!
Nearly every financial planner will tell you that in order to be financially secure, you must diversify. By this, they mean to invest in stocks, bonds, and mutual funds. Unfortunately, this is not true diversification. Rather it is diversification in only one asset class, paper assets—the class where banks make big money in the form of fees. Virtually ignored are the other asset classes, real estate, commodities, and business.
The truth is, this kind of diversification will not necessarily protect you from a flawed system with unlimited downside risk and limited upside potential. That means your retirement plan may not deliver what you need to live on if things do not go as planned, or assumed.
While it is true that the market did eventually rally and come back up after 1929, the facts are that the market was, for all practical purposes, down for nearly 25 years. While that may be a short period of time in the overall history of the markets, bear in mind that when the market plunged from 1929 to 1932, it wiped out 80 percent of most people’s portfolios. Losing 80 percent of everything you spent a lifetime saving would have made those two years into two very long years. So even if the averages state that the markets tend to go up, living through years of successive down markets and watching your portfolio slowly diminish might cause you a few sleepless nights, even if you know that markets eventually do go back up again—as most people assume.
When everything you’re invested in is still on paper, it’s based on the same fragile economy and the same investment model. When the stock market goes down, it goes down everywhere, not just in certain places. Investing in Microsoft and McDonald’s won’t make any difference if the market tanks and everything goes down. Widely investing in different mutual funds spreads that risk around even more, but the risk is still the same and the hit will be the same when things go south.
True diversification is investing across different asset classes, not different stocks. This holds true with any of the asset classes. If I’m invested in condos, apartments, and houses, my portfolio looks diverse, but they’re all still real estate assets. So, I have real estate assets, commodities assets like gold and silver, business assets like my companies, and yes, I have some paper assets as well.
Now I want to restate that the advice of, “Invest for the long term, be patient, and diversify,” is solid advice for those who have limited financial education and investment experience. The point I want to reinforce is the idea that you as an individual have three basic choices.
- Do nothing.
- Follow the same old financial planning advice to diversify.
- Get financially educated.
The choice is yours. Obviously, I recommend long-term financial education. Today, many other people are joining the chorus.
Editor, Rich Dad Poor Dad Daily