RIAs Most Popular Story: Rule of 72: Good for Client Education or Total Hogwash? (May 31)
In this contentious article on investment philosophy, financial advisors faced off over their opinions on the old Rule of 72 guideline ...
Dateline May 31: With interest rates still hovering at historically low levels and stocks pushing new highs, advisor Larry Ginsburg is making sure to talk to clients about the so-called rule of 72.
Such a rule of thumb is used to estimate how long it takes to double an investment’s value. It’s a straightforward formula: divide 72 by an expected annual rate of return. Assuming an average yearly return of 6%, for example, this calculation suggests it will take 12 years to double.
“More advisors would be well-served to talk to their clients about this rule,” says Ginsburg, president of Ginsburg Financial Advisors in Oakland, Calif., which manages $191 million. “I’ve been doing this for 36 years now and the rule of 72 is absolutely the best tool I’ve found to help explain how money works.”
But not everyone is a fan. “The rule of 72 is so general that it blurs the lines between making sound investment decisions and chasing past returns,” says Neal Frankle, an advisor in in suburban Los Angeles who manages $111 million.
The rule is “too simplistic” and promotes a false sense of security about investing, Frankle argues. In his view, such deficiencies can seriously work against an advisor’s efforts to manage behavior and keep clients from bailing on their investment plans.
“People act emotionally, so if they lose a lot in a year or two, they’re going to get nervous if you’ve set their expectations at seeing a doubling of assets within a certain amount of time,” says Frankle.
But Ginsburg believes much depends on how the rule is applied. “As part of a thoughtful and thorough discussion of how money works, the rule of 72 can be very helpful,” he says.
In keeping with this theme, Ginsburg has a photo of Albert Einstein on display in his office. The reason, as he likes to tell new clients, is that the famed physicist once was asked what’s the most powerful force in the universe. His response, according to Ginsburg: The power of compounding interest.
“What I usually tell people is that understanding what Albert Einstein was talking about is probably the most important thing they’ll learn from meeting with me today,” he says.
Einstein realized “how money really works,” asserts Ginsburg. He drives this point home by offering a simple example: An investment of $1 with an expected return of 1%, say, equates to making a penny a year. In other words, it would take 100 years to earn $1. “That’s a very straightforward way of explaining simple interest,” he says.
Next, Ginsburg introduces how compounding works. By contrast, if interest on a family’s nest egg compounds at a rate of 1% every year, he points out, it’ll take just 72 years — not 100 — before their money doubles. He relates such math by observing that “this is why banks battle over an eighth of a percent” when competing for someone’s loan business and savings accounts.
That launches a discussion of the loss of purchasing power clients can see from higher taxes and inflation. At this point, Ginsburg typically steers conversations to concepts like real returns and inflation rates including food and energy costs.
“A lot of people are conservative and afraid, so they don’t want to invest,” he says. “But they don’t realize that if you don’t invest, you’re essentially losing buying power against the ravages over time of inflation and taxes.”
Isn’t such a conversation too basic for many people? “Probably less than 5% of my clients have come to me with a good understanding of the basics of how money works,” says Ginsburg.
David Hultstrom, an advisor in Woodstock, Ga., avoids any references to such rules when he talks to clients.
In his practice, where he works on retainer and manages about $75 million, Hultstrom brings up with new clients that “the risky stuff” — anything other than investment-grade bonds and cash — might be expected to lose half its value in a typical bear market. “That little piece of information is usually enough to focus a discussion on the importance of picking a proper asset allocation that closely matches each investor’s unique appetite for risk,” he says.
Still, Hultstrom, president of Financial Architects, agrees that using the rule of 72 depends on how advisors choose to apply it in educating investors and managing client behavior. The problem, he warns, is that too much talk about such a “general rule of thumb” can quickly turn people's attention to the wrong aspects of investing.
“Salespeople focus on things like how quickly you can double your money,” says Hultstrom. “Professionals focus on downside risk and getting asset allocation right.”
Read the original May 31 article here.