Last week we focused on the importance of managing emotions when it comes to the market. Of course, it would be wonderful if we all could keep our head level when it came to money, but it turns out we are human, instead. Annoying, right? There might be some strategies that help keep us in check, though. Dollar-cost averaging and compounding interest are two investment strategies that might help us manage our emotions and our money a little better.
With dollar-cost averaging, you commit to investing a designated amount of money into a single fund or stock at regular intervals1. That means that no matter what the market is doing, you are still investing, and you are still investing the same amount. Even when the market is low, even when the market is high, even if the market starts to look like the same rollercoaster that makes grown men shriek at Disney World - you keep investing. Seems scary, right? Well, roller coasters tend to terrify you while you’re on them, but they always make you smile at the end - kind of like dollar-cost averaging. If you stay committed for a long enough period, your regular investments will more often than not result in profitability. That’s the real happiest place on Earth, am I right?
I get it, though; it’s not easy to be happy when you see that initial downward spiral. It’s far easier to be pessimistic, but what if we could transform that pessimism into pennies? Well, welcome to Magic Kingdom! Here’s how it works:
Stay Committed
You must stay committed to regular and continuous investments in a single stock or fund, regardless of the market and its many mood swings. That is the key to making the most out of dollar-cost-averaging. Naturally, the amount of shares you can purchase will vary. If the price is high, you buy fewer shares; if the price is low, you buy more. But if you commit a large enough amount of time to consistent investing, the cost you pay per share will likely be a favorable or profitable average.1
401(k) - Same Principle?
If you currently have a 401(k), you are already a member of the dollar-cost-averaging club. Congrats! In a 401(k), an employee selects a set amount of their salary that they would like their employer to invest into a fund that the employee has chosen. That means, every time the employee gets paid, a portion of their salary goes straight to investments. By the end of their career, they have accumulated a significant enough amount of wealth to (hopefully) retire. This wealth has been successfully accumulated because it occurred over a long period of time and because it was consistent. Rather than investing randomly and in a lump sum when the market was good and being subject to lose the second the market turns sour, 401(k)s grow because they ride the waves of the ever-changing market.
An Example:
Let’s say you decide to invest $100 every month in a stock with a $10 cost per share. You have ten shares! Woo-Hoo! But next month, the shares are $5. There goes that first dip in the roller-coaster - your arms are flailing, your hair is standing up straight, the grown man behind you is shrieking again, and you’re thinking about joining him. Still, you invest your $100 and buy those 20 shares because you promised to stay committed...right?
Now picture next month, shares are going for $20. You buy your five shares, and you now own 35 total. The average cost per share over those three months becomes close to $12, which is higher than your initial purchase but lower than the highest price of $20. These are obviously exaggerated numbers, exaggerated fluctuations, and an extremely short timeline relative to what you should aim for if you choose dollar-cost-averaging. Still, it is an example of how you can maneuver through the market by remembering that what goes down will most likely come up. You have successfully lowered your cost basis on average through the process and hopefully made some well-deserved gains over time. Boom! The brilliance of dollar-cost-averaging!
Compounding Interest
So, dollar-cost-averaging helps make money by tuning out your emotions and remaining consistent. But what if our money could make money? Well, dreams do come true. Do I look like Mickey Mouse yet? (No big ear jokes, please).
No, I am not a mouse, and this is not a trap. Compounding interest is another great long-term investment strategy. Similar to dollar-cost-averaging, it requires time and commitment, but it’s worth both.
As your assets sit in an account, they typically earn interest. This interest rate will vary depending on the nature of your assets and the account they belong in. Still, regardless, your earnings typically generate more profits simply by sitting in the account. By compounding interest, your money generates interest earnings on the initial sum as per usual and accumulates interest on the interest it has earned from previous periods. If you’re confused, you’re not alone. It’s probably best to give you an example.
Interest on Interest - How it Works
Let’s say you have an account with assets amounting to $1,000, and you earn 10% interest annually. If you make no contributions and no withdrawals, that $1,000 turns into $1,100. Your account is now up to $100. Ah, doesn’t that look pretty? Well, it can look prettier.
If you have compound interest, that 10% interest rate will be applied to your initial $1,000, and the $100 you earned last year. Next year, you will earn $100 for the initial $1,000, plus an extra $10 for the $100 you made from interest. Your account is now up $110. Ah, the brilliance of compound interest!
Again, these are over-simplified numbers and exaggerated interest rates, but the principle is fundamental. Compounding interest can help you grow your assets exponentially over time, and the more time you allow it, the more it will grow.
Now, listen, money is not magic. There are, of course, aspects of both dollar-cost-averaging and compounding interest that can get a little bit tricky, which is why financial advisors are always a great idea (Ba Dum Tss!). Still, these two strategies are great ways to grow wealth over time and highly recommended options for those just starting their investment journey or recognizing that their journey will be a long one and want to make the most out of it. Regardless, I’m here to help.
Stay Tuned for Part 2!
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes.
Investing involves risks, including possible loss of principal. No strategy assures success or protects against loss. All performance referenced is historical and is no guarantee of future results. Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market. Bonds are subject to market and interest rate risk if sold prior to maturity.
Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax.
Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective.
Options are not suitable for all investors and certain option strategies may expose investors to significant potential losses such as losing the entire amount paid for the option. The fast price swings in currencies will result in significant volatility in an investor’s holdings. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities.
Sources:
https://www.investopedia.com/investing/dollar-cost-averaging-pays/
https://www.investopedia.com/terms/d/dollarcostaveraging.asp
https://www.investopedia.com/terms/c/compounding.asp