There is an old legend about a king who challenged his servant to a game of chess. As they were sitting down to play, the king thought he would quickly triumph, but to everyone’s amazement, the servant won!
The king was so impressed by his skill, he wanted to reward him for what he had done. “You can have anything you want,” the king said. “Thank you sire!” The servant replied and pointed to the chess board, “Please put one grain of wheat on the first square and then two on the next, doubling every square until the board is full, that is my request.” The king’s view of his servant quickly soured, he thought the servant had been foolish because he could have asked for anything in his kingdom.
It was maybe out of pride or laziness, but the king didn’t bother to check to see how much wheat the servant was actually asking for, and so without a second thought, he went ahead and had his man in charge of the grain fill the order. The king’s manager came to him some time later and said “Sire, there isn’t enough grain in the whole kingdom to pay this servant what he has asked…”
The king’s manager came to him some time later and said “Sire, there isn’t enough grain in the whole kingdom to pay this servant what he has asked…”
Albert Einstein calls compound interest the 8th wonder of the world…I would whole-heartedly agree.
I love the Rule of 72. It’s one of those crazy simple ideas that totally changed how I think about investing! With the Rule of 72 , we can quickly figure out how long it takes to double our money at various rates of return.
All you have to do is take the number 72, divide it by the rate of growth you’re either expecting, or that you’ve chosen as your minimum threshold for an investment, and it gives the you the period of time in which it will take to double your money. It allows you to quickly say yes or no to investment opportunities that cross your path, based on your individual goals.
For example, if we want to double our money in 7 years, we then need to say no to all investments with a growth rate of less than 10%, because 72 divided by 7 years equals 10% rate of return needed for a double.
Or say we are looking to double our money every 3 years, we would divide 72 by 3 years, which gives us 24% as our target rate of return.
For Warren Buffett, his minimum investment threshold for the longest time was 26%, now why was it 26%? Because he knew the power of compounding, and knew that he needed to double his money every two or three years to reach his investing goals over time. He was able to achieve these incredible 25-30%+ returns over many decades by being very disciplined in choosing his investments. He knew the power of compounding when time is on your side, much like the servant of the king knew he had every square of that chessboard to double his grain. Warren Buffett knew that if he were disciplined and only stuck to investments he had a good understanding of that were well priced, had great competitive advantages, and were run by really great managers, he was going to become very wealthy… and he did in a major way! Now we’re not Warren Buffett, we’re not geniuses, but I think we can do very well by following this principle.
The Rule of 72 also works inversely with each set of growth rates and years to double: If we want to know how long it would take to double at a rate of 3%, we can divide 72 by 3% which gives us 24 years to double, and 72 divided by 7% lets us quickly know it will take 10 years to double. We don’t need to be precise to the decimal because we’re using these number to help us quickly decide on investment opportunities that come across our path, and if we want to dig deeper on them or not. To quote the brilliant John Maynard Keynes – ‘We would rather be vaguely right, then precisely wrong.’
Then, what you can do is, when looking at earnings growth, or balance sheet growth, you can quickly see how a company has performed over time by making the calculations in your head…
Then, what you can do is, when looking at earnings growth, or balance sheet growth, you can quickly see how a company has performed over time by making the calculations in your head, and either make the decision to dig deeper on a certain company or take a pass. So, if you’re looking for a minimum 20% plus return, the company will need to have doubled earnings, or book value, or cash flow in the last 3 or 4 years. Take a look at this company called MTY Food group (MTY:TSE) And we can quickly see some pretty near doubles in some big numbers right away. This would definitely peak my interest to take a closer look because it could fall into my minimum 20% threshold. I use Morningstar for finding these numbers quickly.
(In Morningstar, for example type in ‘AAPL’ in the search bar, then click ‘financials’ then click ‘All financial data’ at the bottom – scroll to the end of this post for detailed steps. Don’t worry about specific numbers right now, I’ll get into what numbers you need to know in another post. Don’t be intimidated, we only need four or five.)
This simple method of being able to quickly calculate returns has been such a time saver, and I hope it can do the same for you! Let me know if you have any questions in the comments!
(Oh, and in case you were wondering, the servant’s request ended up being a twenty-digit number. 10,000,000,000,000,000,000)
(Morningstar steps to find financial statements.)