3.3 Consistency and compounding

What this topic covers:

  1. Why invest regularly?
  2. The benefits of dollar cost averaging
  3. The magic of compounding
  4. Dividend Reinvestment Plans

Understanding the value of regular investing

As we saw earlier, our medium term investor got distracted by the opportunity of making a quick buck. If you’re serious about growing your wealth steadily over the long term then it’s important to remain focused on your goals.

The power of “little and often” can’t be stressed enough. Investing the same amount at regular intervals stops you trying to “time the market” (i.e. buying low and selling high). Instead, regular investing helps you spread your entry into the market over different time periods – an investment strategy known as dollar cost averaging.

What is dollar cost averaging?

Dollar cost averaging is an investment strategy where you make a regular investment rather than a one-off lump sum, thereby “staggering” your entry to the market. In other words, as we show in the example below, you invest say $250 a month over 4 months rather than $1,000 in one go.

The reason for this is that as share prices fluctuate, if you happen to invest your $1,000 when the price is higher, you’ll receive fewer units than if you invest when the price is lower. Of course, it’s impossible to say when the price will go up or down, so dollar cost averaging can help you even out the risk of investing a lump sum when the price is high.

At the end of 4 months you would own 1,283 units, whereas, if you had invested $1,000 in month 1, you would have 1,000 units.

Effectively, you have created a larger position in this stock investing exactly the same amount of money. By spreading out your investment and buying at different points in the market you were able to take advantage of those months when the price was a little lower. In this way, your portfolio can continue to grow over time, without feeling the need to “time the market”.

Risk analysis – the cons of dollar cost averaging

  • Dollar cost averaging doesn’t guarantee profit and it’s not suitable for short-term investing.

  • If market prices keep rising, the average purchase price could end up being higher than if you’d invested a lump sum.

  • Regular investing attracts fees. Bear this in mind when you decide how often to invest.

You can try this strategy with the CommSec Pocket app. Simply set up a regular investment and contribute the same amount in the same ETF every fortnight or month. It’s easy to set up, and as your investment is on autopilot, from there on you don’t have to constantly monitor it.

The magic of compounding

You’ve probably heard of compounding. It’s one of those financial terms that gets bandied about, because it really is a useful thing to know. Here’s how it works.

If you have money in a savings account, that money will earn interest. When the interest is paid – usually at the end of the month – if you don’t withdraw that interest, then when your next interest payment is calculated, it’s calculated on the larger account balance (so you’ll earn even more interest). And so, it goes on.

Compounding works the same way for investments.

Picture this. Each time you receive a dividend, distribution or income payment from your investment, rather than take that money as a cash payment, you reinvest those funds to buy more units or shares. If the company continues to perform well, your reinvested earnings will then generate additional earnings. The longer your money is invested, the bigger the effect compounding can have. As it can make a significant difference to the value of your investments exponentially over time – it’s a really powerful tool to have in your locker. Try it out for yourself with this compound interest calculator.

Take advantage of Dividend Reinvestment Plans

Many companies offer shareholders the option of a Dividend Reinvestment Plan or DRP. With a DRP, you can increase your investment in a company over time by automatically reinvesting your dividends. Rather than taking the dividends in cash, you’ll be using them to buy more shares in the company. A DRP has many advantages, including:

  • You may receive the option of reinvesting your dividends in shares at a discounted price to the listed price

  • Reinvesting in the company’s shares means you could benefit from dollar cost averaging

  • If the company continues to pay dividends in the future, you’ll benefit from compounding (because the number of shares you own will grow over time, and dividends are paid at a rate per share)

  • You will increase your holdings in the company, increasing the size of your investment and growing your portfolio

A-REITs (a Real Estate Investment Trust that owns and operates income-producing real estate) and ETFs may also offer unit holders the chance to participate in distribution reinvestment plans, automatically using their cash distributions to buy additional units in the fund.

Next topic: 3.4 Diversification


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