At this time of year 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.
The Rule of 70 is a simple rule that allows you to understand the effects of inflation on buying power. It 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.
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 nine per cent, an investment of $100 will grow to $200 in eight years.
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 nine per cent, will grow to $300 in just under 13 years.
Inflation is an enemy that all of us must be concerned with, especially when investing for the long term. After all, at just two per cent inflation the cost of a $100 basket of groceries can double to $200 in 35 years.
In other words, you would either have to pay $200 for that same basket of groceries or significantly reduce your lifestyle by purchasing $50 in groceries. These are not the best alternatives when you are retired, so you must take into account the long-term impact of inflation on your retirement savings or suffer the consequences.
Earlier, I used a nine per cent interest rate to demonstrate that $100 invested today would grow to $200 in eight years: the Rule of 72. However, that nine 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 nine per cent interest rate, assuming three per cent inflation, is approximately six per cent, after inflation.
Applying the real rate of interest to the rules 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 12 years to grow to $200 and just over 19 years to grow to $300.
In either case, that is a 50 per cent 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 this year, make sure you take into account the rules of 70, 72, and 115, because if you ignore the effects to inflation you may end up having to make the harsh decision in retirement of having to buy $50 rather than $100 of necessities.
I’ll end this column with what I tell all of my students: you are in control of your financial destiny.
Patrick O’Meara is an instructor and co-ordinator of the financial services diploma program at Red Deer College.