The Rule of 72 and You

The Rule of 72 is a handy little tool for evaluating risk. If you want to know how long it will take to double your money at some given interest rate, just divide that rate into 72. For example a 2% interest rate takes 72/2=36 years to double your investment. With a 5% rate it only takes 72/5=14.4 years to double your money.

Right now the Federal Reserve Bank has driven the interest rate on bonds and savings accounts down to nearly zero. They are punishing savers in an attempt to get them to do something more risky with their money in hope of juicing the economy and lowering unemployment, especially in the building trades. The Federal Reserve also hopes with interest rates at historic lows, you will not only spend your savings but borrow some 30 year mortgage money at the unheard of rate of 4.74%.

Unfortunately, the Federal Reserve Bank also likes controlled inflation in the 2%-3% range. The Rule of 72 also applies to that side of the problem. If inflation runs at 2% in 72/2=36 years, it will cut the value of your money in half. If 3%, it only takes 72/3=24 years to cut the value of your money in half. In the 1970s inflation was running at 10%. At that rate it only takes 7 years to cut the purchasing power of a dollar to 50 cents.

I wondered what applying the Rule of 72 to one of my more unusual, perhaps riskier, investments might tell me. Back in May of 2007, I purchased 650 shares of GE Capital Corporation 6.45% notes, ticker symbol (GER), with the sole intent of generating $1,000 of annual income, actually $1,048.12. GER is an example of a preferred stock, sometimes called preferred shares. It is neither this nor that. It is not a bond which is essentially a loan with a fixed principal and interest rate. It is not a share of common stock that represents a small portion of ownership in a great corporation. It is something in between. It has no inherent value beyond the interest it generates. If the company goes belly up or even just suspends the dividend payment on a preferred share, its value rapidly drops to zero. Companies issue these things when they need some quick cash and they are pretty certain they can beat the interest rate they are paying the investor. In this case the money was probably used in their credit card program or some similarly lucrative activity. Following the crash of 2008, Warren Buffet bought $3 Billion of GE Preferred. He got a better deal than I did, 10%. Of course I only had $17,000 to help bail out GE Capital. Preferred shares have an expiration date, at which time the company will return the initial value of the shares to the owner and call it quits. The company also has the option of redeeming the shares whenever they think they can get a better deal. Recently GE redeemed Warren Buffet’s $3 Billion special issue shares. Mine are good to 2046 or when GE gets tired of me, which ever comes first.

Given the Rule of 72, my shares pay a current rate of 6.28%. Over the years the share price has dropped a miniscule amount so the actual interest rate is actually closer to 6.25%. Lets apply the Rule of 72. 72/6.25=11.5 years. I have held these shares for 4.5 years, so only 7 years to go before all my initial investment is off the table. I think I can live with that risk. I don’t think GE is going out of business any time soon. The real calculation is more complicated than I want to fiddle around with. It involves logarithms and calculations based on what I actually did with dividends (that went into other investments because I can’t use my favored Dividend Reinvestment Plan with a preferred stock). I am content that this is a pretty good guess. I offer it to the reader as one of many such tools to help quantify risk.

Now, Let’s be careful out there.