How to Spot What's too Good to Be True: The Rule of 72
You may have heard the saying 'If it sounds too good
to be true, it probably isn't true'. But how do you work
out what is too good to be true?
Start with the rate of return you have been offered.
Most investments illustrate their rates of return using
percentages. While that's reasonable, research suggests
that many people have trouble working out percentages,
especially in their heads.
Use the Rule of 72
One way to tackle this problem is to work out how long
it would take to double the money you originally invested
if you reinvested all your returns. This is simpler than
it seems. Before calculators or spreadsheets, investors
used the old 'Rule of 72'.
How the Rule of 72 works
Suppose you were offered an investment with a return
of 10% per year and you reinvested all your returns. How
many years would it take to double the value of your original
investment? The Rule of 72 says that you divide 72 by
the annual rate of return to get the number of years it
will take to double your money. So for 10% per year:
72 divided by 10 = 7.2
which means that at this rate of return, it will take
a bit over 7 years to double the value your original investment.
If you get a 20% per year return, it will take over 3½
years to double your money. If you get only 3% per year
you will have to wait 24 years.
The Rule of 72 is not absolutely precise, but it gives
you a practical estimate that you can work out in your
head.
Who wouldn't want to be a millionaire?
Before you start dreaming of a very high return, ask
yourself this: Could you safely and seriously expect to
make that much money that quickly? Remember, you're probably
not the only person investing in the scheme. If you are
getting unbelievable returns, so are all the other investors.
Just think — if 3,000 people each put in $10,000
(and many people put in much more), then everyone would
be a millionaire after 10 years. The whole scheme would
be worth $3 billion. Common sense should tell you that
something about these numbers just isn't right.
By Australian Securities and Investment Commission
