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September 2020

The Compounding Effect and Dollar Cost Averaging

The global economy has been adversely affected by the COVID-19 pandemic this year. Many people worry about whether their MPF investment will be affected by market volatility. Although the total assets in the MPF System decreased to $868 billion in March 2020, they rebounded, exceeding $1 trillion in July, reflecting the resilience and stability of the MPF System.
 
Since the MPF is a long-term investment, scheme members should not be overly concerned about short-term volatility, and should not underestimate their monthly MPF contribution. According to MPFA statistics, as at the end of December 2019, 62,900 MPF accounts had accrued benefits of more than $1 million. This shows that the longer the investment period and the more the MPF contributions, the more retirement savings will be accumulated thanks to the power of the compounding effect and dollar cost averaging. Let’s see how these concepts work.  
 
The Compounding effect

Assuming there are investment gains, the accumulated amount of an investment will be greater than the growth of the investment horizon. This is because when MPF members invest their contributions in an asset, the principal generates interest, which is then reinvested together with the principal to generate even more interest. This roll-over effect is like a snowball rolling downhill, getting bigger and bigger over time.
 
If a scheme member starts to work and make MPF contributions at the age of 20, assuming his monthly contribution is $1,000 and the net investment return per year is 5%, he will accumulate $440,000 by the age of 40. If he invests for 20 more years, which means a total of 40 years, he will get
an investment return of $1.53 million if he retires at the age of 60. Although the time horizon only doubles, his savings triple, showing that the larger the monthly investment, the greater the savings because of the compounding effect.
 
Dollar Cost Averaging

Dollar cost averaging means that a fixed amount is invested regularly in a particular investment, regardless of unit price.  When unit price is low, the same amount buys more units, and vice versa.
 
Dollar cost averaging is a prudent investment technique, which mitigates the effect of short-term market fluctuations on investments by averaging out the costs of the units over time. As scheme members make regular contributions to their MPF funds at regular intervals, they are effectively using dollar cost averaging without even realizing it.

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