Friday, January 15, 2021

The Nexus Between Compound Interest and Dollar-Cost Averaging

Personal financial planners who recommend compounding strategies to clients who are planning for their retirement will often mention dollar-cost averaging. You probably know that compound interest boils down to generating exponential profits from set earnings; this involves reinvesting proceeds into the assets you hold. Dollar-cost averaging is the perfect complement to compounding, and it consists of periodically investing a set dollar amount into a conservative financial instrument.

How Dollar-Cost Averaging Relates to Compound Interest

Virtually all descriptions of compound interest investing will mention dollar-cost averaging without specifically referring to it. When a financial planner tells you the advantage of making regular contributions to a 401(k) plan, for example, she is in fact making a dollar-cost averaging recommendation.

Let’s say open a $200 high-yield savings account with Citibank in December 2020. With a 0.70% interest rate compounded monthly, in five years, you will have $207.12. When we introduce dollar-cost averaging at a rate of $200 contributed each month, your total savings after five years will be almost $12,416.

Investment Strategy with Compound Interest

Compound interest and dollar-cost averaging are not limited to savings accounts, certificates of deposit, bonds, or money market accounts. Billionaire investors such as Warren Buffett have amassed fortunes applying these principles to their stock portfolios. Keep in mind that equity securities do not offer compound interest; however, some of them pay dividends that can be saved up and used to buy more shares. To a great extent, dollar-cost averaging is the opposite of timing the market; it requires discipline to ignore Wall Street fluctuations and continue to invest the same amount each month, but the potential rewards are certainly worth the effort.

To a great extent, dollar-cost averaging is the opposite of timing the market

Many banks will provide you with investment tools that automate the contribution process. A typical example would be a high-yield savings or money market account that automatically deducts from the checking account where your paychecks are received via direct deposit. The last thing to remember in relation to dollar-cost averaging is that profits cannot be assured if you do it for stock investing. When the market turns against investors, your periodic contributions could generate losses; when this is the case, you will need to make a decision in terms of adjusting your portfolio.

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