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How to spot what's too good to be true: the rule of 72
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 could be 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 perfectly 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 trusty 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 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 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 a shade 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.
A real-life example: the ‘Wattle’ scheme
Let's use the Rule of 72 in a real case from the ASIC files.
The ‘Wattle’ scheme was one of Australia's worst investment disasters during the late 1990s. More than 3,000 Australians, including police and health care workers, invested about $160 million dollars in an illegal investment scheme that promised 50% per year return, paid each month.
Using the Rule of 72:
72 divided by 50 = 1.5
This would mean that, as an investor in the scheme, you would double your money in less than 1½ years. Sound good? It sounds even more tempting when you realise that you'd double your money again inside another 1½ years.
Imagine if you started with $10,000. You'd end up with $40,000 in less than 3 years because you’ve doubled your money twice. Within 10 years, you'd be a millionaire! Your original $10,000 would have multiplied 100 times.
So, who wouldn’t want to be a millionaire?
Before you start dreaming of paying off your mortgage and taking the kids to Disneyland, 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 a whopping $3 billion, a scheme as large as one of the top 50 companies on the Australian sharemarket. Common sense should tell you that something about these numbers doesn’t add up!
What the Rule of 72 says
The Rule of 72 indicates that this scheme does sound ‘too good to be true’.
As it happens, the Wattle scheme turned into a disaster for investors. While it supposedly made profits for investors by lending funds to new businesses, the Wattle scheme was really a Ponzi scheme that paid investors out of its own capital, not from the profits it was earning. ASIC got the scheme closed down and the man running it has been sentenced to ten years jail, subject to appeal.
By using the Rule of 72, you can find out if an investment return really is ‘too good to be true’, and avoid being taken in by scams.
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FIDO Website: Printed 08/21/2008
