72 IS THE MAGIC NUMBER

By The Sick Economist

It might surprise you to know that math was never one of my better subjects in school. That’s right, a guy who published four books about finance, founded two separate finance websites, and has achieved financial independence through investing, couldn’t tell you the square root of anything. When evaluating my finances I hold onto my calculator like a liferaft. Without Excel Spreadsheets doing everything for me, I might be selling vegetables on the roadside to grind out a living.

But here is the second big surprise: one of the most powerful mathematical concepts in finance is also the most simple. None of us need to know why or how it works, as long as we know that it works. As a certain Ex-President might say, it works “bigly.”

I am talking about the “Rule of 72.” The rule of 72 is a simple way that you can calculate in your head how long it will take for a number to double. It works like this: You take the growth rate, expressed as a single or double digit number, you divide 72 by the number, and the result is the amount of time it will take for something to double.

This works for any kind of calculation, but it’s especially powerful when trying to understand the long term growth of dividends. Here is a real world example.

Let’s say you buy a stock that has a dividend growing at 10% annually. It currently pays $2 per share. How long will it take until the annual payout hits $4 per share? Even a math challenged fellow such as myself can figure this out. 72/10=7.2 . So, your $2 dividend will become $4 in just 7.2 years.

But what if you happen to have bought a really good company, and it can maintain that 10% annual dividend growth for twenty consecutive years? Well, now the dividend will double in just 7 years at a 10% growth rate. That means that it will QUADRUPLE in 14 years, and OCTUPLE in approximately 21 years. So, your $2 initial dividend will grow to $16 in 21 years!!

Living Proof

If you participate in the financial media at all, you are probably aware of Warren Buffett. Warren Buffet has a curmudgeon-like, grandfatherly appearance, probably just like a million great uncles who fall asleep at Thanksgiving Dinner across America. He just happens to be the richest grandpa who has ever lived, with a networth that currently hovers somewhere around the $150,000,000,000 mark.

How the heck did this old guy get so rich? Did he invent something that we all use? Nope. Is he the son of some kind of famous magnate, like the Rothschild clan? Nope. Is he secretly the dictator of some small, oil rich nation? Nope.

Buffett simply got rich by owning stocks. Owning some very good stocks for a very long time. Despite notoriously subsisting on a diet composed almost exclusively of cheeseburgers and regular coca cola, Buffet is still going well into his 90’s. I don’t know much about the biology of his eating habits, but I can comment on the anatomy of his fortune.

The “Oracle of Omaha” has exhibited famously good investment judgment over the decades. But first and foremost, is the importance of the “decades.” 99% of Buffett’s fortune only accrued to him in old age! Why would that be?

Well, remember that “magic” dividend that went from $2 to $16 in just twenty one years? What if that were 40 years? Remember, by the rule of 72, if the dividend grows at a rate of 10% a year, it doubles every 7.2 years. Now 40/7 is equal to roughly 6. This would mean that Buffet’s dividends would have doubled SIX TIMES after his 50th birthday. So, remember that $2 dividend? It would have grown to roughly $128 between Buffett’s 50th birthday and 90th birthday. That’s with him spending each and every day doing….nothing. Turns out the best way to get rich as hell is simply to buy great dividend paying stocks, find a way to shelter them from taxes, and just do nothing for long periods of time.

Common Growth, Uncommon Profit

Of course when one really examines the life of Buffett, there are plenty of things he accomplished that weren’t so easy; otherwise everyone would be a nonagenarian mega billionaire. For example, maybe the dividend growth rate that I cited above (10% annually) was unrealistically high. If the rate of dividend growth had been lower, then the compounding would have been lower, and Buffett, who invented nothing, wouldn’t be discussed in the same paragraph as Elon Musk or Mark Zuckerberg.

According to the website multpl.com, the median dividend growth across the S&P 500 has been 6.43% since 1990. So, if you had exercised very little judgment at all, and just bought a broad assortment of brand name companies in 1990, by the rule of 72, your dividend would have doubled every 11 years (Approximately). So, over 40 years, a portfolio yielding $2, would now yield approximately $30. Not enough to make you a featured speaker on CNBC, but certainly enough to pay for a gold plated retirement!

But you might have actually done better than that. Over that same time period, the maximum annual dividend growth, achieved in 2012, was 18.2%. In one year, the average dividend payout grew by 18%! In that same period of time, there were at least 10 years where dividend payouts grew in the double digits. If you had exercised a little judgment in stock picking over the last 40 years, you may have actually equaled the 10% annual growth rate that we used as an example.

Simple Math, Powerful Math

A common pitfall for new investors is to feel overwhelmed by supposed experts who make investing seem like a jungle of complex math. They love to use ratios, graphs with many data points, and even jargon in foreign languages (typically, Greek)! A lot of these data points can be useful for experienced investors, but whether they are strictly necessary or not is highly debatable.

With just a basic understanding of arithmetic, and a few simple formulas, the average investor can go far. The rule of 72 is one of those simple formulas. It can help you understand the astounding relationship between time and compound investment returns. If you can take the number 72 and divide it, you have enough mental firepower to grow rich over time.