Three rules that Mr. Money invests by
At the best of times investors get overwhelmed with the choices they have regarding their retirement savings.
Should I invest in GICs, mutual funds, stocks or bonds? These and many more options leave many confused and more than a little bewildered.
Perhaps there is a simpler approach to making long-term investment decisions? I would like to suggest your starting point be a broader, more strategic focus.
Understanding the rules of 70, 72 and 115 can help to focus your investment decisions because they allow you to understand the effects of inflation and time on long-term investments. In fact, they are rules that my friend Mr. Money’s success is based upon.
The Rule of 70 is a simple rule that allows you to understand the effects of inflation on buying power. The Rule of 70 states that the number 70, divided by the rate of inflation, gives the number of years that it will take for the price of a basket of goods to double. For example, if inflation is three per cent, goods that cost $100 today will cost $200 in 23 years.
So from Mr. Money’s perspective, if he wants to have the same standard of living far into the future, he needs to ensure that what he can buy today he has a reasonable chance of buying in the future.
The Rule of 72, 72 divided by an interest rate, helps to determine the approximate number of years that it will take for an investment to double in value. For example, assuming an interest rate of five per cent, an investment of $100 will grow to $200 in just over 14 years.
In contrast, the Rule of 115, 115 divided by an interest rate, helps to determine the approximate number of years that it will take for an investment to triple in value. An investment of $100, invested at five per cent, will grow to $300 in just under 23 years.
Inflation is an enemy that is of great concern to Mr. Money, especially when investing for the long term. After all, at just two per cent inflation, the cost of a $100 basket of groceries would double to $200 in 35 years. In other words, Mr. Money would either have to pay $200 for that same basket of groceries or significantly reduce his lifestyle by purchasing $50 in groceries.
These are not the best alternatives, especially if Mr. Money plans to retire early, and like many Canadians live a much longer lifespan. Every financial plan must take into account the long-term impact of inflation on retirement savings. Otherwise the retiree will suffer the financial and non-financial consequences.
Earlier, I used a five per cent interest rate to demonstrate that $100 invested today would grow to $200 in 14 years, using the Rule of 72. However that five per cent interest rate is what finance professionals refer to as a nominal rate.
In other words, it does not take into account inflation. Future retirees must focus on real interest rates — interest rates that are adjusted for inflation.
So a five per cent interest rate, assuming three per cent inflation, is approximately two per cent, after inflation.
Applying the real rate of interest to the Rule of 72 and 115 results in a longer time frame for your investments to double or triple. In real terms, $100 invested today would need 36 years to grow to $200 and almost 58 years to grow to $300. In either case, that is a substantial increase in the time required for your investments to grow in real (after inflation) terms.
So when you begin your search for that perfect investment, make sure you take into account the rules of 70, 72, and 115, because if you ignore the effects of inflation you may end up having to make the harsh decision in retirement of having to buy less rather than more of the necessities.
Remember, you are in control of your financial destiny.
Easy Money is written by Patrick O’Meara, an instructor at Red Deer College’s Donald School of Business. He can be contacted at Patrick.O’Meara@rdc.ab.ca.