The Money Café - Riyad Mohammed Article Archives

YES, IT CAN! Before we take the required steps to address the Rule of 72’s impact on your retirement; let us take one step back and explain the mysterious mathematical formulae. 

The Rule of 72; states any interest rate, divided into 72, will give you the required years for your capital to double. As an example, if I invested $10,000 @ a 6% rate of return; it will take 12 years to double; therefore, $10,000 invested at 6% will grow to $20,000 in 12 years.

The Rule of 72 has a direct correlation to your retirement, for starters, if you are betting on the wrong horse (your investment portfolio) your expectations versus your reality will be vastly different. As an example, let’s say you started a monthly RRSP contribution investment plan with a blended portfolio mix that doesn’t correlate to your risk tolerance; your retirement funding will realize a shortfall.

Let us expand further; at age 35, most Canadians have a 30-year investment timeline to their prescribed retirement age of 65; however, when the portfolio was constructed, it projected a compounding rate of 8% annually; at an 8% annual rate of return, you can predict what your retirement nest-egg would look like.

However, if your risk tolerance changed and those changes were not reflected in your investment mix, your long-term projected nest egg may not be sufficient to sustain your retirement*. I will dive into an actual example, later in this article, which will further explain the significance of the Rule of 72.

* At this point, I would like to add a few key points on timelines. Most Canadians are not aware of their own mortality; we are thankfully living longer and healthier and instead of your retirement being 10-15 years, it's now closer to 15-20. When you create your long-term retirement plan; make sure your future income (indexed of course) will provide you with income for 15-10 plus years.

The Rule of 72 also applies to inflation; at a 2% inflation rate; the cost of goods and services will double in 36 years (72/2 = 36). Why is this important, when you are creating your portfolio, you must factor in a minimum inflation rate of 2%; some advisors may even go higher and peg inflation at 3%? The only advantage of factoring a 2% or 3% inflation rate, would be if you outperformed the rate of inflation.

Based on 2021’s low-interest environment, we are projecting a conservative 5% annual rate of return; however, when you add an inflation rate of 2%; your new rate of return target should be 7%. Therefore, if you are staying put with a 7% rate of return; you know your capital will double in 10.28 years (72/7 = 10.28) years.

The last thing you would ever want in your investment portfolio is to build it on some lottery windfall. Yes, at times, some sectors beat the market, which produced a much higher annual rate of return, my advice; that’s the gravy, do not focus on these bumps. You know, if in 2022, your portfolio generates a 12% rate of return due to a couple of stocks within your investment mix took off; say thank you, and quickly revert to your 7% target.

For those of you who are old enough to remember the technology bubble of 1998, before its severe correction, everyone and their mother were making money if you were invested in the technology sector. Fortunately, I lived thru that era, and I saw clients who tool my advice and clients who didn’t take my advice, allows the greed factor to set in and suffered for it. 

WORD OF CAUTION: Do not chase last year's returns and expect the same in the current year. I would run out of fingers and tows of clients who insisted on going against our recommendation and greedily dumped more money into the sector. I can also point out clients who followed our advice, took all their profits off their surging portfolio, and deposited the profits into a calmer, steadier blend of balanced and income funds.

As we conclude with this week’s article; the lesson here is to pay attention to your portfolio's projected rate of return and continuously monitor the impact the Rule of 72 will have in your journey. Staying too long into a low-interest fund or not getting out when advised can work against you.

So, the next time you discuss a rate of return; quickly do the math and calculate the number of years in which your capital would double; have some fun with it, but be aware, make sure your risk tolerance is reflected in the blend of your investment mix. 😊