Dollar-cost averaging is an investment strategy that aims to reduce the impact of volatility on the purchase of assets.
Active trading can be stressful, time-consuming, and still yield poor results. However, there are other options out there. Like many users, you might be looking for an investment strategy that is less demanding and time-consuming. Or just a more passive investment style.
But what if you want to buy crypto but don’t really know how to start? More specifically, what would be the optimal way to build a longer-term position? In this article, we’ll discuss a popular strategy known as DCA, or dollar-cost averaging.
What is dollar-cost averaging?
Dollar-cost averaging is an investment strategy that aims to reduce the impact of volatility on the purchase of assets. It involves buying equal amounts of the asset at regular intervals.
By buying at regular intervals, users can potentially smooth out the average price that they acquire an asset at. Let’s see how DCA works and why you might want to consider using it.
Why use dollar-cost averaging?
The main benefit of dollar-cost averaging is that it reduces the risk of making a bet at the wrong time. Market timing is among the hardest things to do when it comes to trading or investing. Often, even if the direction of a trade idea is correct, the timing might be off – which makes the entire trade incorrect.
If you divide your crypto buy up into smaller chunks, you may have better results than if you were buying the same amount of crypto in one large transaction. Making a purchase that’s poorly timed is surprisingly easy, and it can lead to less than ideal results. What’s more, you can eliminate some biases from your decision-making. Once you commit to dollar-cost averaging, the strategy will make the decisions for you.
Dollar-cost averaging, of course, doesn’t completely mitigate risk. The idea is to smooth the entry into the market so that the risk of bad timing is minimized. Dollar-cost averaging absolutely won’t guarantee a successful trade – other factors must be taken into consideration as well.
Now, if you’ve determined a target price (or price range), this can be fairly straightforward. You, again, divide up your investment into equal chunks and start selling them once the market is closing in on the target. This way, you can mitigate the risk of not getting out at the right time. However, this is all completely up to your individual trading goals.
Some people adopt a “buy and hold” strategy, where essentially the goal is to never sell, as the purchased assets are expected to continually appreciate over time.
If you look at an index like the S&P500, which aggregates the performance of the top 500 publicly traded U.S. companies (ranked by market cap). While there are short-term periods of recession, when you zoom out, you can see that the S&P500 has been in a continual uptrend. The purpose of a buy and hold strategy is to enter the market and stay in the position long enough so that the timing doesn’t matter.
However, it’s important to keep in mind that this kind of strategy is usually geared towards the stock market and may not apply to cryptocurrency markets.
Dollar-cost averaging example
Let’s look at this strategy through an example. Let’s say we’ve got a fixed dollar amount of $10,000, and we think it’s a reasonable bet to invest in Bitcoin. We think that the price will likely range in the current zone, and it’s a favorable place to accumulate and build a position using a DCA strategy.
We could divide the $10,000 up into 100 chunks of $100. Each day, we’re going to buy $100 worth of Bitcoin, no matter what the price. This way, we’re going to spread out our entry to a period of about three months.
Now, let’s demonstrate the flexibility of dollar-cost averaging with a different game plan. Let’s say Bitcoin has just entered a bear market, and we don’t expect a prolonged bull trend for at least another two years. But, we do expect a bull trend eventually, and we’d like to prepare in advance.
Should we use the same strategy? Probably not. This investment portfolio has a much larger time horizon. We’d have to be prepared that this $10,000 will be allocated for this strategy for another few years. So, what should we go for?
We could divide the investment into 100 chunks of $100 again. However, this time, we’re going to buy $100 worth of Bitcoin each week. There are more or less 52 weeks in a year, so the entire strategy will execute over a little less than two years.
This way, we’ll build up a long-term position while the downtrend runs its course. We’re not going to miss the train when the uptrend starts, and we have also mitigated some of the risks of buying in a downtrend.
But keep in mind that this strategy can be risky – the hypothetical user would be buying in a downtrend after all. For some investors, it could be better to wait until the end of the downtrend is confirmed and start entering then. If they wait it out, the average cost (or share price) will probably be higher, but a lot of the downside risk is mitigated in return.
Dollar-cost averaging calculator
You can find a neat dollar-cost averaging calculator for Bitcoin by using any number of "Dollar Cost Averaging", or DCA calculators. You can specify the amount, the time horizon, the intervals, and get an idea of how different strategies would have performed over time.
The case against dollar-cost averaging
While dollar-cost averaging can be a lucrative strategy, it does have its skeptics as well. It undoubtedly performs best when the markets experience big swings. This makes sense, as the strategy is designed to mitigate the effects of high volatility on a position.
According to some, however, it’ll actually make users lose out on gains when the market is performing well. How so? If the market is in a sustained bull trend, the assumption can be made that those who invest earlier will get better results. This way, dollar-cost averaging can have a dampening effect on gains in an uptrend. In this case, lump sum investing may outperform dollar-cost averaging.
Even so, most investors don’t have a large chunk available to invest in one go. However, they may be able to invest small amounts over the long-term – dollar-cost averaging can still be a suitable strategy in this case.
Dollar-cost averaging is a redeemed strategy for entering into a position while minimizing the effects of volatility on the investment. It involves dividing up the investment into smaller chunks and buying at regular intervals.
The main benefit of using this strategy is the following. Timing the market is difficult, and those who don’t wish to actively keep track of the markets can still invest this way.
However, according to some skeptics, dollar-cost averaging can make some users lose out on gains during bull markets. With that said, losing out on some gains isn’t the end of the world – dollar-cost averaging still can be a convenient investment strategy for many.
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