Establishing a sturdy foundation for your financial health starts with saving money. At some point, however, it might be time to look beyond accumulating funds for a rainy day and consider making an investment.
A good way to tackle questions around saving and investing is through the Rule of 72.
How Much to Save
The first step to making an investment is deciding how much money you want to keep in savings, and how much you can afford to invest.
Most people opt to keep three to six months of living expenses in their checking or savings account, as liquid assets: in other words, money you can quickly access in case of a healthcare emergency, unexpected home repairs, car trouble and so on. Keeping a three-to-six-month cushion is also extremely useful in case of unemployment – a situation that unfortunately, many people faced in the aftermath of COVID-19. A savings account means you can handle these financially stressful situations, without generating debt.
The precise amount you should keep in a liquid savings account depends on your unique circumstances. Families with children usually take a more cautious approach and will aim to keep more money in savings, rather than investments. A younger adult might favor investments over savings, if their monthly expenses are low and they’re eager to get a head start on growing their capital.
Doubling Your Money: The Rule of 72
Savings accounts offer many important benefits including security, reliability and easy access to funds: but they don’t offer a very high rate of return. The average annual interest rate on a savings account is under 0.1%. What does that number mean and how does it compare to investing your money in stocks or bonds?
To understand how money grows, it’s helpful to look at the Rule of 72.
The Rule of 72 is a formula to determine about how long it will take an investment to double. Simply divide the number 72 by the fixed annual rate of return. The resulting number is the number of years until the investment doubles. For example:
- If your account earns 1% per year your money will double in 72 years
- If your account earns 5% per year your money will double in 14.4 years
- If your account earns 10% per year your money will double in 7.2 years
- If your account earns 15% per year your money will double in 4.8 years
According to the Rule of 72, if a savings account offers an annual interest rate of 0.1%, it would take a hypothetical 720 years for the money in your account to double.
Of course, the purpose of a savings account isn’t to grow your money: it’s to keep it safe and give you easy access to funds. If growing your money is a priority, and you have the funds and knowledge to do so smartly, then it might be time to consider making an investment.
Estimating a Return on Investments
The most critical thing to remember about investing in the stock market is that it’s not possible to predict future profit based on past returns. In other words: investments bring risk.
Saying that, it’s also true that the average annual return for the S&P 500 Index over the past 90 years is around 10%. This is why S&P 500 index funds are often cited as an excellent choice for new investors looking for a diversified way to invest in stocks. According to the Rule of 72, an index fund that averages 10% return per year would double its initial investment in just over seven years. If the market is less robust and the rate of return is closer to 6%, an investor could still double the account in 12 years.
Of course, many factors are at play and there’s no guarantee when it comes to the stock market. In any given year, depending on the stock or mutual fund, a rate of return could be 0% or lower. Investors with less appetite for risk may instead choose to put their money into bonds or certificates of deposit (CDs), which usually offer a higher interest rate than a savings account, with less risk than stock or index funds.
The Question of Debt
When considering how much to save and how much to invest, it’s also important to talk about debt. Saving or investing without paying off debt is like running a race with two lead shoes: you’ll move toward your financial goals at a much slower pace. Debt interest almost always grows at a faster pace than interest on an investment, so before looking at where to invest, focus on paying off debt.
Curious about how your debt could compound over the years? Here too, you can use the Rule of 72 to estimate when your balance will double – which is a great motivator to develop a plan and get it paid off.