When it comes to investing, there are a plethora of strategies with varying degrees of risks. One such strategy is dollar-cost averaging, which is designed to build wealth over time. This is an investment approach in which periodic purchases of assets ultimately eliminate the need for timing markets. Sounds confusing? Continue reading to know more about this strategy and how to use it effectively in your crypto operations.
Dollar-Cost Averaging: What Is It?
Dollar-cost averaging (DCA) is a less-measured investment plan that helps investors eliminate emotion-based decisions. Here, the investor looks to mitigate the effect of price volatility by spreading purchases across predefined intervals. Instead of investing a lump sum in an asset class, the investor chooses to invest a fixed amount weekly, monthly or on a bimonthly basis. This is done regardless of the changes in prices.
Think of dollar-cost average as a viable means of navigating a volatile market without having to gauge the best entry point. Since the capital is spread across predefined intervals, the strategy tends to smoothen your purchase prices over the duration of the investment. This is a lot better than investing a lump sum at a peak price.
In essence, we can say that dollar-cost averaging is a suitable investment strategy for beginners or individuals who do not want to burden themselves with the technical aspect of market analysis.
Also, note that dollar-cost averaging is ideal for long-term investors. The goal is to stick to an investment cycle where a fixed amount is consistently invested in an asset. There is no room for doubt, greed or fear associated with short-term investment strategies. It is also worth mentioning that dollar-cost averaging is more effective in a bear market. While most investors are too afraid to buy, always wondering if they are too early or too late to the game, your dollar-cost averaging plan would provide you with an investment framework for buying the dip.
Now that you know the fundamentals of dollar-cost averaging, let's take a look at the possible effects of this strategy in various investment scenarios.
How Does Dollar-Cost Averaging Work?
Before we dive into the technicalities involved, let us paint all the possible outcomes of a lump sum investment strategy. As an example, let’s say that you decide to invest a lump sum of $1,000 in an asset worth $50 per share. As such, you can purchase 20 shares in a single purchase. So, what happens if you choose to sell when the price is at $40, $60, or $80?
From the table above, it is clear that the lump sum strategy works best when the investor has identified the best time to enter a market — that also means that you would need to choose to sell at the right time. Let us compare this baseline with the potential outcomes of the dollar-cost averaging strategy.
Dollar-Cost Averaging in a Bear Market
Since dollar-cost averaging is a continuous buy plan, you would need to spread your $1,000 capital over multiple purchases. For instance, you could have a dollar-cost averaging plan for buying an asset over four months. In other words, you set aside $250 per month. Perhaps the price dips steadily such that at each predefined time interval the prices are $50, $35, $30 and $25. In this case, the $1,000 investment capital has accrued 30.4 shares. How then does this strategy affect your profit if you choose to sell at the same sell prices?
Because you managed to purchase more shares over time, your investment grows faster. Even where the lump sum strategy posted a loss, the dollar-cost averaging manages to generate a profit.
Dollar-Cost Averaging in a Bull Market
While dollar-cost averaging is an effective strategy during a bear market, it is not as potent in a bull market. When your purchase prices increase over time, the shares accrued will be lesser than the number of shares you would have bought with a lump sum. For instance, you can split $1,000 equally across four purchases and the prices per share are $50, $65, $70 and $80. With this purchase plan, you will end up with 15.5 shares. How does this impact your profit?
From the table above, you will notice that the profitability of your investment diminishes considerably.
Dollar-Cost Averaging in a Flat Market
The third scenario is when the price of the asset is somewhat stable over time. Here, you will not feel the impact of dollar-cost averaging. For instance, the purchase price of an asset moves sideways and posts $50, $55, $40 and $60 at each interval at which you invest $250. In the end, you would have a total of 18.9 shares which is a little closer to the 20 shares bought for a lump sum of $1,000 at $50 each.
Is Dollar-Cost Averaging Suitable for Crypto Investing?
As you must have noticed, the dollar-cost averaging strategy is suitable for any volatile investment class. Because cryptocurrency is second to none when it comes to volatility, it is not as easy to predict the eventuality of price movements. This is why you might need to adopt the dollar-cost averaging strategy to even out your purchase prices and take advantage of market dips.
However, it is critical to ensure that you do not suffer significant losses during a bull cycle. Note that dollar-cost averaging is more potent when the prices of digital assets are experiencing a decline.
To use dollar-cost averaging as a crypto investment strategy, you could opt for brokerage services that offer periodic purchase options. Alternatively, you could set up a purchase plan manually by choosing a fixed amount to invest at predefined intervals.
What Are the Benefits of Dollar-Cost Averaging?
From our examples above, it is safe to say that dollar-cost averaging amplifies the profitability of investment by taking advantage of price dips. Other advantages include:
- It helps avoid risks arising from the mistiming of markets;
- It eliminates emotion-based investment decisions;
- It is suitable for those interested in long-term investments.
What Are the Drawbacks of Dollar-Cost Averaging?
The obvious drawback is the increase in transaction fees. Considering that this strategy entails multiple purchases, the trading cost may increase significantly, especially when using crypto brokerage services for fiat-to-crypto exchanges. However, depending on your profitability and the duration of the investment, you may not necessarily feel the effects of the extra overhead cost arising from periodic purchases as against buying with a lump sum. There are also potential losses as a result of the consistent surge of the price of the asset. The higher the purchasing prices over time, the lesser the impact of dollar-cost averaging.
Dollar-cost averaging is a potent investment strategy for beginners and less technically-inclined investors, especially when investing long-term in a volatile market. As discussed in this guide, the probability of mistiming the market is low, and the risks resulting from emotion-based investment decisions are reduced.