Can Dollar Cost Averaging Make You Rich?

The ideal way to make a fortune in the stock market is by predicting the future. If you can make each purchase when the price is at its lowest, then sell when it peaks – in other words, buy low, sell high – you will maximize your profits. The trouble is that no one, including successful investors like Warren Buffett, Peter Lynch, and George Soros, has found a reliable method of consistently predicting how the market will behave.

Anything can and does happen with individual stocks, indexes, and the larger stock market. Unexpected crashes like the ones that occurred in March 2020 can take investors by surprise, and the subsequent k-shaped recovery added to the debate over what the market might do next. Ultimately, only one thing is certain. From the first time the stock market opened for trading through the present day, it has always recovered its losses and gone on to reach new heights. 

There is no guarantee that this historical pattern will stay consistent forever, but for now, it is the closest that traders can possibly come to a sure thing. The question is how to make the most of that trend. Savvy investors choose a dollar cost averaging strategy to ensure that they get the benefit of every market rise. 

What Is Dollar Cost Averaging?

Dollar cost averaging is a technique intended to take the guesswork out of investing. Instead of trying to buy and sell at precisely the right moment, which doesn’t tend to be successful, investors make purchases at regular intervals, regardless of price. 

Every purchase is for the same dollar amount, though the asset price fluctuates. That volatility becomes less important because the regular purchases ensure investors capture all of the highs and the lows.

At the end of the allotted period, the average cost of the asset reflects the pricing journey. Highs and lows don’t cause the sort of concern that they would with a lump sum purchase, and there’s no such thing as poor timing. 

How Do You Explain Dollar Cost Averaging

The best way to explain dollar cost averaging is with an example that many people can relate to: 401k investments. Most of these programs permit employees to have contributions withheld from their paychecks, and employees generally contribute the same amount to their plans each pay period. 

At the end of the contribution period, such as when the employee leaves the company or retires, the assets in the 401k plan reflect dollar cost averaging.

When prices were high, fewer shares were purchased. When prices were low, more shares were purchased. The result is a portfolio that captured the ups and downs of the entire contribution period, which minimizes the risk of selling below the purchase price when it’s time to take a distribution. 

Can Dollar Cost Averaging Make You Rich?

The question of whether dollar cost averaging can make you rich has a nuanced answer. It can, but not in a winning-the-lottery sort of way.

Dollar cost averaging is highly effective at building wealth, but only when investors make smart choices about the underlying assets and they give the process enough time. In addition, they must have the discipline to make contributions at regular intervals for the strategy to work. 

There is a caveat to this – dollar cost averaging can make you rich if the market stays true to its historical growth trend. In a situation where the asset being purchased with a dollar cost averaging strategy declines in value, investors have losses – and sometimes those losses are significant. 

Dollar cost averaging will mitigate some of the damage, but it can’t create gains where none exist. Therefore, using a dollar cost average strategy to purchase mutual funds, index funds, or exchange-traded funds (ETFs) that reflect broad indexes is more likely to make you rich than buying a handful of individual stocks. 

Best Way To Dollar Cost Average

The best way to dollar cost average begins with selecting the right asset. Broad indexes that reflect the diversity of the market are most likely to see long-term gains. Examples of funds that aim to mirror the returns of large indexes – or the market as a whole – include: 

• iShares Core S&P 500 ETF (IVV)
• iShares Russell 3000 ETF (IWV)
• Schwab Total Stock Market Index (SWTSX)
• SPDR Portfolio S&P 500 ETF (SPLG)
• SPDR S&P 500 ETF (SPY)
• Vanguard S&P 500 ETF (VOO)
• Vanguard Total Stock Market Index Admiral Shares (VTSAX)
• Wilshire 5000 Index Investment Fund (WFIVX)

After selecting the fund or funds that best meet your financial goals, choose a dollar amount – or in the case of payroll deduction, a percentage of your total pay.

Set up an automatic transfer and purchase shares at regular intervals, e.g., weekly, bi-weekly, or monthly. Then, leave your investment alone to grow in value. 

This is where the discipline comes in, as it can be tempting to increase your purchases when it appears the price of the asset is climbing. Worse still, you might be tempted to sell your shares when the price is on the decline – but don’t if you want to stick with the DCA plan. The key to dollar cost averaging is ignoring short-term volatility in favor of long-term gains. 

Dollar Cost Averaging Formula

Most brokerage firms include a dollar cost average for each asset along with the other details about your holdings.

However, if you wish to calculate the figure yourself, the dollar cost averaging formula is simple: Add all of your contributions together to get the total cost of your shares, then divide the total cost of your shares by the total number of shares. 

For example, you purchased $100 worth of XYZ ETF shares each week for one year. You now own 78 shares. 

• $100 x 52 = Total Contribution of $5,200
• $5,200 / 78 shares = $66.67 average cost per share

Reverse Dollar Cost Averaging Explained

The primary use of a dollar cost averaging strategy is to acquire assets, but there are some investors who use a reverse dollar cost averaging strategy when taking distributions from their portfolios. For example, this may occur when retirees must take minimum required distributions from tax-deferred accounts. 

Essentially, reverse dollar cost averaging involves regular withdrawals of equal amounts under the same theory that this reduces the impact of market volatility. However, in practice, reverse dollar cost averaging isn’t as effective as other distribution strategies.

Reverse dollar cost averaging works when the market is on an upward trend, but when it is in decline, there is significant risk to this strategy. The impact of systematic withdrawals is amplified when the market goes down.

As a result, retirement savings don’t provide the expected income for the necessary amount of time. In many cases, that means a need to make unwanted lifestyle changes. 

Support from an expert in retirement planning is critical during the distribution phase to ensure that the timing of withdrawals is optimized for value and for tax liability. 

Is Dollar Cost Averaging A Good Idea? The Bottom Line

Dollar cost averaging takes some of the excitement out of investing, so it isn’t for those who are seeking a gambling-like thrill.

Instead of completing intensive technical analysis and attempting to buy or sell at the right moment, the dollar cost averaging process is far more routine. That makes dollar cost averaging a good idea for investors who don’t have the time or interest to dedicate to choosing investments, but less so for investors who have a real passion for playing the stock market. 

It’s worth noting that dollar cost averaging reduces the likelihood of a sudden cash windfall – the sort that might occur with a pair of trades timed just right. That’s the experience that keeps many investors coming back for more.

However, practically speaking, such windfalls are unusual. It is far more common to lose principal than it is to generate dramatic gains overnight. So, for most investors, the bottom line is that dollar cost averaging is a good idea. 

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.