Dollar cost averaging (DCA) involves making incremental buys of an asset on a regular basis. Also referred to as recurring buys, DCA is an investment tool used for accruing wealth over a long period of time. Dollar cost averaging removes the emotional aspect of investing in volatile assets like cryptocurrencies and helps average out the price through price spikes and drops.
Dollar-cost averaging is an investment strategy that has been around for generations. If you are just beginning to build your investment portfolio, you will probably hear about it on investment forums or from your financial advisor.
Either way, dollar-cost averaging is a great way to reduce market risk, especially in a volatile market such as the cryptocurrency market.
A dollar-cost averaging strategy involves dividing the total amount of funds you want to invest into portions that can be invested periodically such that you buy an asset regardless of the asset’s market price.
The whole idea here is to remove the tiresome and most difficult task of timing the market for the right entry point. For instance, if you have $10,000, you can divide it 10 times and buy Bitcoin in weekly intervals or monthly intervals depending on your preference.
With such a strategy, you will no longer need to worry about the fundamentals or technical analysis that influence price on that week or month. All you have to do is buy, no matter the price.
Following a dollar-cost averaging strategy can be useful, especially in a bear market as it allows you to buy the asset at its lowest value as you slowly build your position in that asset. Instead of making a lump sum purchase, you work your way into owning more of the asset with small purchases over a long time.
This strategy is designed to insulate the investor against volatile price swings or fundamental changes in the market. Therefore when the market eventually turns bullish, you will end up making more profit than you would have made with a lump-sum purchase. Likewise, when the market is bearish, your downside will be lesser than an investor who made a lump-sum purchase.
Here are several examples of how a dollar-cost average strategy would work in different market conditions.
First, let’s look at the difference between a dollar-cost averaging plan and a lump-sum purchase.
Imagine you have a total of $10,000 to invest in the crypto market and your target is to buy as much Bitcoin as possible. In this hypothetical universe we have created, Bitcoin’s price is at $250 per coin. Instead of waiting and timing the market for a perfect entry point, you decide to go with a dollar-cost averaging strategy.
So you divide your $10,000 four times and create a plan to invest in Bitcoin for a whole year regardless of its price at the time of buying. This means that each month, you will buy 2,500 worth of Bitcoin, no matter the price. Let’s imagine that by the end of the year, the following price points have been your average entry points every three months.
Therefore, by the end of the year, you have accumulated a total of 45.45 BTC compared to the 40 BTC you would receive with a lump sum purchase at the beginning of the year.
Now that you have 45.45 BTC. Let’s imagine that you plan to sell, and let’s look at how much profit you will make compared to the lump sum strategy at different sell prices.
As you can see, while both strategies began with the same amount to invest, the dollar-cost averaging strategy achieved a higher amount of bought BTC and eventually sold at higher profits than the lump sum purchase strategy.
If the market started falling from an ATH of $500 BTC after the accumulation of your 45.45BTC, the profit and loss report would look like this compared to the previous table.
As you can see, just as the upside is greater for the dollar-cost averaging strategy, the downside hits the lump sum buyer harder.
The only time when a dollar-cost averaging strategy appears weak compared to a lump sum purchase is when the market is going up for an extended period. For instance, if a lump sum buyer (LS from now onwards) bought BTC at $500 with a $10,000 investment and our dollar-cost averaging investors (let’s call him DCA) bought incrementally at $500, $600, 800 and $1000, this would be the final result.
Eventually, DCA will have 14.825BTC compared to LS’ 20 BTC. While it is possible for the lump sum buyer to outperform DCA in the shorter term (a few days or weeks), a market correction will soon put DCA in the lead. In the long term, such a scenario where a market rises and continues to rise for a long period is unrealistic in most cases. The reality is that the market will rise and fall over the long term allowing the dollar-cost averaging investors to gain more BTC.
There is a simple mathematical formula you can use to dollar cost average into your positions. The formula is called the Harmonic mean and goes like this:
Although it might look complicated, it’s a simple formula that you can use to determine how long it will take for you to achieve your goal and even how much you would need to spend at every price point.
To break it down further:
H = the average price you pay for an asset over the accumulation period
n = the number of times you purchase
x1 and x2 = the price you pay with every purchase
Therefore if you were to invest $6,000 in 3 months buying $2,000 worth of a token over that period, the formula would look like this:
H = 3/(1/500 + 1/200 + 1/400) = 315.78
Over the three months, your average entry price would be $315.78
As you can see from the examples we have shared above, the dollar-cost averaging strategy is easy to follow. You can pretty much compare it to a retirement fund where you deposit a specified amount every month. While it is easy to talk to a broker to invest in a stock portfolio, applying a dollar-cost averaging plan to a crypto portfolio is a different cup of tea.
Since there is no brokerage firm, you need to find reliable crypto exchanges where you can keep your funds. For this strategy, you will need a stable coin in your wallet. For instance, if you have $10,000 to invest, you can perform a one-time transaction and buy a stable coin with the entire amount. Hold those Stablecoins in a cold wallet and only make a transaction to the exchange when making a purchase. Holding a stablecoin in your wallet will help you avoid the repeated costs of exchanging your fiat into crypto with every transaction. It will also save you time.
Once that is done, you can schedule monthly or weekly purchases on the exchange. If the exchange does not feature such a function, you can set alerts every month as reminders to make purchases manually.
As a bonus point, you can also invest in an interest account or stake your stable coin for rewards as you reinvest the earned interest to make even more gains on your buying positions.
Sure, there are some scenarios where the lump-sum approach beats the dollar-cost averaging strategy. However, those scenarios heavily rely on timing the market and being early to find favorable prices.
While timing the market for profitable entry points can be practical for a full-time day trader, investors who have other businesses to run prefer the dollar-cost averaging strategy as it helps avoid mistiming the market. The dollar-cost averaging plan also helps the investor take emotion out of the process as the investor assumes a long-term perspective of the market.
Ultimately, a dollar-cost averaging plan will save you from forming psychological biases in your decision making as is common in the market.
Every market is made up of investors who develop different emotions at different stages of the market cycle. These collective emotions are related to the market cycles and can determine market direction. Every investor in the market is looking to make a profit. At the beginning of a market cycle, investors have a positive outlook about the asset; therefore, they jump in and buy.
As hype and excitement continue, a snowball effect catches on and more investors join the fray. The price continues to rise as buying pressure increases and now investors start to feel thrilled and euphoric given the gains they are making. Suddenly, the buying pressure for the asset dies out and the market shows its first signs of weakness. Anxiety sets in and those investors who bought in at an early stage start to sell given the huge profits made. As the selling pressure continues, denial sets in as investors refuse to believe that the bull market is over and that a bear market is underway.
Fear, depression, and panic follow as the market continues to go down wiping out all the previous gains. It is at this point that most investors choose to sell out on their positions to avoid even bigger losses. This cycle repeats itself when investors start to have hope about the asset.
With dollar-cost averaging, you can avoid this emotional roller coaster that controls the decision-making process of most investors.
A dollar-cost averaging plan is ideal for a bear market where prices are going down as it allows you to buy the dip with every market correction. In a bull market with rising prices, a lump sum purchase will outperform the dollar-cost averaging approach as the dollar-cost averaging approach will buy fewer assets as the price goes up. In a bull market, a lump sum approach will likely lock in a good entry position and buy the most units of an asset at lower prices. The risk of buying a lump sum is not knowing when a market is about to turn bearish.
Another disadvantage of the dollar cost averaging plan is that it is not a substitute for doing your research and picking the best-performing investments. Before identifying your target asset, it is important to look at the fundamentals as well as the technical analysis to determine whether the investment (though in a bear market) will eventually resume into a bull market.
What’s more, while the dollar cost averaging approach allows an investor to ignore short-term price changes, the investor should continue paying attention to the changes in the asset’s fundamentals. This is because new information can change the future projections of an asset.
For example, an asset might fail to achieve a goal or be abandoned by its stakeholders. Such an asset would continue in its bear trend, never to resume a bull market. Therefore, even though the investor will accumulate a significant amount of the asset, the risk of total loss would be greater.
Whether you like the lump sum approach or the dollar-cost averaging investment strategy, investing in any market requires attentive learning of the different concepts of investing. For new investors, the dollar-cost averaging approach is a safe and easy approach to forming a position with an asset class as it removes the difficulty of timing the market. You also get to avoid the emotional swings of the market. As you expand your knowledge in investing, be sure to check out other investment strategies that you can add to your knowledge and experience.