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The basics of compound interest and dollar-cost averaging

The basics of compound interest and dollar-cost averaging

Jeff Rosenberger, PhD

Every day we engage in activities in an effort to take better care of ourselves. Trying new exercise routines, choosing fresh over processed foods at the grocery store, scheduling regular checkups with our care providers — these are all things we do to feel better today, and to help ensure a healthier tomorrow. However, it can sometimes be easy to forget to take the same preventative approach when it comes to our finances.

Saving for retirement is one of the easiest ways to set your future self up for success, and there are many strategies designed to help individuals reach their goals. As with any financial decision, consulting with an advisor or tax professional can help determine what's best for you.  

In this post, we’re going to cover two you might’ve heard of before — compound interest and dollar-cost averaging.

Keep reading to learn:

  1. How long-term investing can help you save for retirement
  2. The potential impact compound interest can have on your retirement savings
  3. An easy method to build retirement into your budget

Investing for retirement

Long-term investing is a lot like riding a bike. While anything new is unfamiliar at first, it can be exhilarating once you get the hang of it.

Consider a child learning to ride — they’re mostly focused on simply not falling. If you don’t have the opportunity to ride a bike until you’re an adult, you may be more worried about your posture, technique, and any variables that might lower the likelihood of you falling and injuring yourself. You can absolutely learn to ride a bike as an adult, but you may be more likely to psych yourself out than a child might.

Once you learn to ride a bike, it’s off to the races. Have you noticed that once you know how to ride a bike, you tend to not lose that muscle, even if it’s been a few years? Just like riding a bike, often the hardest part of long-term investing is getting started. While all investing involves risk and it can seem scary to make yourself vulnerable to volatility, it’s important to consider how investing compares to other long-term savings vehicles. Additionally, when time is on your side, you have the benefit of being able to ride out much of the volatility that comes with investing in the market.

According to the FDIC, as of September 19, 2022, the average interest rate for a traditional (liquid) savings account is .17%, and the average interest rate for a 60-month (or 5 year) CD is .74%. While there are high-yield accounts that may boast higher rates, these will be highly variable based on market conditions. In comparison, one could expect the average rate of return on a diversified investment portfolio to range from 5-8%.¹ With these figures in mind, you could stand to see your hard-earned money grow by at least 6x more by investing with a diversified portfolio than by simply keeping it in the bank.² That number only gets magnified as you consider the ability for your accounts to tolerate more risk when you have a longer amount of time to save.

Ok, that was a lot to digest. Let’s try to break it down a bit.

Short-term vs. Long-term: 10 years is a safe place to draw a line in the sand to denote long-term when it comes to finances. This isn’t scientific and can differ based on an individual’s broader financial situation, tolerance for risk, and financial goals. For many, retirement is a financial goal that is more than 10 years away and thus can be considered a long-term financial goal.

Risk tolerance: People typically think of themselves as being more open to risk or more likely to avoid it. When you think about risk tolerance with saving money for a goal, it’s important to consider time as a critical ingredient (even if it’s not in your nature to select the safer option or vice versa.)

When something is further away (i.e., long-term like retirement), your investment can accommodate more risk. Conversely, when your goal is approaching sooner, your investment may benefit from playing it a bit safer. While there are a few contributing factors here (two of which we will go into detail below), the most important thing to remember is that markets will always fluctuate. Generally, history has shown that when you have time to allow for it, investment  accounts will not only have time to recover from market downturns, but the chance to bounce back and grow.

Compound interest

Compound interest is the “interest on interest” that your investments or savings earn.³

What does that mean?

The short answer: The investments in your retirement account portfolio will earn interest. That interest can be reinvested in your account, increasing the shares of investments you have. While the earnings may seem small at first, as the cycle continues to repeat itself, over time the amount of interest you earn from an investment could grow alongside your account value.

You’ve got my attention. How does it work?

Your retirement portfolio is likely made up of some combination of stocks, bonds and possibly cash investments. You may have even noticed mutual funds which could encompass stock, bonds, or exchange-traded funds (ETFs) as underlying investments.

Without getting too technical, when invested in mutual funds, the underlying investments may have a dividend, which the fund manager then passes along to those individuals who are invested in the mutual fund according to their invested amount. A dividend is the distribution from the mutual fund’s earnings to its investors. The dividend payment you receive will depend on the amount of the dividend and the number of shares you have in your portfolio.

Depending on the funds included in your portfolio, dividends may be paid out monthly, quarterly, or annually.

At Guideline, when a dividend gets paid out, that amount will automatically get reinvested in your account. As your account continues to grow — thanks in part to continued contributions and in part to the reinvestment of your investment earnings — so does the amount you’re invested in the mutual funds that make up your portfolio. As you continue to increase the number of shares you have of a given mutual fund, your potential for additional dividends may increase as well. And they’ll get reinvested. That is the magic of compound interest.

Don’t my other accounts benefit from compound interest?

While other investment accounts (like a non-qualified account that doesn’t qualify for tax-advantages) allow you to reinvest your earnings from dividends, they will be reported as earned income for tax purposes. The same goes for other accounts you might have, like a non-qualified high yield savings account (HYSA) or money market account.

Retirement accounts are tax-advantaged accounts and one of those advantages is that contributions and earnings grow tax-deferred. Unlike a non-qualified brokerage account where dividends are treated as ordinary income (and therefore taxed as such) even when reinvesting, dividends earned in retirement accounts (like a 401(k) or an IRA) are reinvested into your account without incurring a tax burden at the time of earning the dividend.

If you have 401(k) or IRA funds in a pre-tax (or Traditional) account, you will pay income taxes when you withdraw in retirement. If you have funds in a Roth 401(k) account (or Roth IRA), qualified withdrawals that meet IRS requirements will not be subject to income taxes (since contributions were made on an after-tax basis).⁴

Why is compound interest important for my retirement plan?

Compound interest has the power to make it possible for even a modest account to grow over the course of your career and why it’s so important to contribute to retirement accounts as soon as you can. Even if you can’t contribute much to start, you’ll be setting a strong foundation for your retirement. And thanks to compound interest, every little bit counts and has the potential to turn into so much more.

Dollar-cost averaging

Before we dive directly into the next concept, let’s take that bike back out for a spin.

If we consider compound interest to be the wheels on the bike going round and round, progressing you forward towards your destination, dollar-cost averaging is the act of pedaling. Ongoing, consistent pedal strokes will continue to power the wheels.

Let’s imagine we’re on a leisurely ride along a paved bike bath. You’re on autopilot. Pedaling comes naturally and the wheels are turning with little resistance. This is what it is like when you contribute to your long-term investing account regularly and is the perfect pairing of dollar-cost averaging and compounding interest at work.

As nice as autopilot is, we all know it won’t always be that easy. Sometimes you’ll meet some resistance and need to pedal harder. Maybe your budget is tighter for a few months and you need to cut back on how much you contribute. And sometimes it might feel as if you don’t need to pedal at all. Perhaps you’ll get a raise and you won’t flinch at the thought of increasing your contributions. At the end of the day, the important thing is that you keep on pedaling.

So what exactly is dollar-cost averaging?

Dollar-cost averaging is almost as literal as the name implies.⁵ It is a strategy that involves investing the same amount of money on a periodic schedule (e.g. monthly) so that an investor will generally average out the price of the shares they’re purchasing, reducing the impact of the market’s volatility.

By putting equal amounts of money into the same investment, spaced out over regular intervals, dollar-cost averaging makes it possible to reduce the overall impact that market volatility has on the price you pay to acquire more shares of your investments. Instead of only investing when the market is doing well, one can manage risk by investing over a period of time to average out the price you’ll pay for those investments.

How can I start to invest with dollar-cost averaging?

Making contributions to your 401(k) is a great way to get started. While dollar-cost averaging is not limited to 401(k)s, making 401(k) contributions from your paycheck is the perfect example of dollar-cost averaging. If you are contributing 5% of your income during a pay period to your 401(k), whether it be via pre-tax or Roth contributions, the same amount will be deducted from your paycheck each time. That money will be automatically deposited into your 401(k) account and invested into the market. We cover the difference between Traditional and Roth 401(k) contributions in more detail here.

Why is dollar-cost averaging important for my investing strategy?

Dollar-cost averaging helps to minimize the risk associated with investing in the market.

Because the market is always fluctuating, dollar-cost averaging allows investors of all levels of savviness — whether you’re just starting or you’ve been investing for some time — to benefit from market gains and mitigate risk from market declines.

While timing the market (or, trying to buy shares when the value drops and sell those shares once they increase in value) can have the potential to generate big wins, there is generally more risk involved when trying to do so. Like gambling, while there can be big wins, there can be big losses too, and most people can’t afford to gamble away their retirement savings. Dollar-cost averaging allows investors to benefit from both the market gains and the market losses without needing to be an expert investor that has the time and know-how to excessively track the market.

Are there other benefits of dollar-cost averaging?

If lowering your exposure to risk is not enough of a selling point for you, dollar-cost averaging is also a way for you to build investing into your budget.

Because consistency is key to dollar-cost averaging, determining an amount you can contribute on an ongoing basis (just like you might for groceries, rent, or other recurring bills) will help you to train yourself into thinking of it as part of your budget. This applies both to determining how much you can comfortably afford to contribute to your 401(k) as well as if you are incorporating additional investing (like an IRA or other non-retirement brokerage account) into your broader financial plan.

Key takeaways

We know there's a lot to learn and digest when it comes to saving for retirement, so to recap, here are a few things to take away from this post:

  • Long term investing is just that — long term. It takes time to accumulate and grow your wealth. Remember that as often as your accounts will grow alongside market growth, they will also inevitably decrease in value when the markets are weaker. While that can be scary, don’t let that discourage you from sticking to your strategy. With time on your side, your account can recoup its value when the market becomes strong again.
  • Consistency is key. Always do whatever you can to keep pedaling the bike, even if you’re going uphill. Continuing to contribute (even if you need to lower it from time to time) is one effective way to keep your retirement-saving strategy on track. You’ll be participating in the market in an easy and responsible way that doesn’t require an economics degree.
  • Take advantage of your tax advantages. Not all investment accounts come with the same tax advantages as retirement accounts. While it may seem insignificant, not paying taxes on your earnings from dividends can add up over time (especially as your account grows.) Ultimately, it’s more money in your pocket. Consider what tax-advantaged (or qualified) accounts you have access to when building out a retirement savings strategy that’s right for you.
small business way to 401(k)

The information provided herein is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax advice that considers all relevant facts and circumstances. Guideline makes no representations or guarantees with regard to investment performance as investing involves risk and investments may lose value. Clients should consult a qualified investment or tax professional to determine the appropriate strategy for them.

¹ A diversified investment portfolio is an investment strategy where underlying investments are chosen across different sectors in hopes of reducing overall risk.

² Average rate of returns for a diversified portfolio, lower-end return of 5% per source provided, and higher end of 5 year CD of 0.74%. 5% is 6.76x greater than 0.64%.

³ Compound interest is when interest is applied to initial investment and reinvested dividends and/or capital gains. There are several factors to take into consideration when determining compound interest such as initial investment amount, applied interest rate, frequency of interest applied, and total years invested.

⁴ For Roth accounts, withdrawals of contributions and earnings are not taxed provided it's a qualified distribution, which constitutes that the account is held for at least 5 years and the withdrawal is made on account of disability, on or after death, or on or after attaining the age of 59 1/2. Please refer to the IRS’ Roth Comparison Chart for additional information.

Dollar Cost Averaging is an investment strategy of investing a fixed dollar amount on a regular basis, regardless of market conditions. It in no way guarantees growth within an investment account as timing of purchases may be during periods of market highs or lows and it does not take into consideration fees.