Compounding and Dollar Cost Averaging: Tools For Capital Growth

  • February 10, 2022
  • malikshehu
  • 4 min read

Investing invokes two strong emotions: “I’m not seeing results as fast as I’d like” and “I really, really don’t want to lose any money.” These two characteristics — impatience and loss aversion — might prevent you from benefiting from volatility and long-term investing

There are two concepts that can help you understand those advantages: compounding and dollar cost averaging. This article will highlight, using examples, why compounding and volatility in the markets are your best friends.


Compounding is interest on your interest.

Compounding is when the interest on your money makes money. If you invest $1,000 today at 10% interest for 5 years, your investment grows to $1,100 after a year. In two years, the interest is 10% on $1,100, not $1,000. This comes to $1,210. In year 3, your interest is 10% on $1,210, and you get $1,331; and so on. 

Below is how your account will look after 5 years:

YearInvestment at the beginning of the year ($)Interest RateInterest Earned ($)Amount at the end of the year ($)
Year 11,00010%1001,100
Year 210%1101,210
Year 310%1211,331
Year 410%133.101,464.10
Year 510%146.411,610.51

What happens if you decide to make five annual payments at the beginning of each year instead of just one? Compounding helps by increasing the interest earned as each new investment fetches interest and is added to the previously accumulated interest. If you invested $1,000 annually at a 10% per annum interest rate, your account at the end of five years will have $6,715 in it. Here’s how:

YearInvestment at the beginning of the year ($)Interest Rate Interest Earned ($)Amount at the end of the year ($)
Year 11,00010%1001,100
Year 21,00010%2102,310
Year 31,00010%3313,641
Year 41,00010%464.105,105.10
Year 5 1,00010%610.516,715.61

In summary, compounding means that the longer and more patient you are, and the more you invest, the more money you stand to make. 

Dollar Cost Averaging

Dollar Cost Average means being consistent with investments regardless of market volatility.

When you have a long time horizon, you can benefit from the ebb and flow of the financial markets. In investing, we strive to “buy low and sell high”. But trying to determine the lows and highs is futile because we can’t time the market.

Dollar cost averaging means ignoring market timing and simply investing a consistent dollar amount periodically, regardless of whether the markets rise or fall.

Let me explain with an example. 

Suppose Ari, a first-time dad and newbie investor, has a discretionary income of $500 every month. He wants to get ahead of his daughter’s university fees by planning and investing in advance. He decides to invest $200 every month into a growth oriented mutual fund, regardless of how the financial markets are doing.

The mutual fund will have a unit price — which is the total value of the mutual fund divided by its number of shares. This unit price fluctuates over time — a concept known as volatility. We can calculate how many units Ari can buy with his money at any given time using the following formula:

Units Bought = Amount Invested / Unit Price

Let’s assume the unit price is $10 when he starts investing in January. As the unit price fluctuates, the amount of units Ari buys varies and accumulates.

At the end of the year, to calculate his total portfolio value, we’d multiply the December Total Cumulative Units by the December Unit Price. We can see that his fund value after one year in a volatile market is $5,370.94.

MonthUnit Prince ($)Amount Invested ($)Units BoughtTotal Cumulative UnitsFund Value ($)
April 4.8620041.15107.10520.52

If he invested in a fund whose unit price consistently rose since January, he’d be buying fewer and fewer units each month, leading to a lower fund value at the end of the year. This is what it’d look like: 

MonthUnit Price ($)Amount Invested ($)Units BoughtTotal Cumulative UnitsFund Value Per Month ($)

Comparing the two scenarios, it’s clear that a constant dollar amount invested into a volatile market fares better than a constant dollar amount invested into a market with a consistently rising unit price. This is because when markets fall, unit (share) prices are cheaper and you get more units for your money. When these unit prices eventually rise, your total fund value rises as well. 

This is how dollar cost averaging works to your advantage in the long run. 

Compound your earnings

Take advantage of financial markets through compounding and dollar cost averaging to increase your wealth significantly. The sooner you implement these concepts in your investment strategy, the more money you’ll make over the long term. If you’re not sure how to start or where to invest, reach out to a certified financial advisor to help you grow your wealth.