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A primer on dollar-cost averaging, a long-term investment approach.
Cryptocurrency price volatility, such as Bitcoin, can occur on a daily (or even hourly) basis. Volatility, like any other form of investment, can cause uncertainty, fear of missing out, or apprehension about participating at all. When prices are changing, how do you know when to buy?
In a perfect world, it would be as simple as buying cheap and selling high. In fact, even for professionals, this is easier said than done. Instead of attempting to “time the market,” many investors employ a method known as dollar-cost averaging (or “DCA”) to mitigate the impact of market volatility by investing a lesser amount in an asset — such as cryptocurrency, stocks, or gold — on a regular basis.
DCA might be the right choice when someone believes their investments will appreciate (or increase in value) in the long term and experience price volatility on the way there.
What is DCA?
DCA is a long-term approach in which an investor buys smaller quantities of an asset over time, regardless of price (for example, investing $100 in Bitcoin every month for a year, rather than $1,200 all at once). Their DCA schedule may alter over time, and it may last a few months or several years, depending on their goals.
Although DCA is a popular approach to acquire Bitcoin, it is not exclusive to cryptocurrency – conventional investors have been using this technique to weather stock market volatility for decades. You may already be using DCA if you invest via your employer’s retirement plan every payday.
What are the benefits of DCA?
DCA can be an efficient approach to hold cryptocurrency without the infamously tough effort of market timing or the possibility of unintentionally utilising all of your cash to invest “a lump sum” at a high.
The key is to choose an amount that is reasonable and to invest on a regular basis, regardless of the price of an item. This has the ability to “average” out the cost of purchases over time, reducing the overall impact of a rapid decrease in costs on any individual purchase. And, even if prices fall, DCA investors may continue to buy as planned, with the possibility to make profits when prices rebound.
When is DCA more effective than lump-sum investing?
DCA can let an investor enter a market securely, begin profiting from long-term price gain, and average out the risk of short-term price fluctuations. And in cases like the ones listed below, it may provide more predictable returns than investing a large sum of money all at once:
Buying an asset that may increase in value over time. If an investor thinks prices are about to go down — but are likely to recover in the long term — they can use DCA to invest cash over the period of time they think a downward movement will happen. If they’re right, they’ll benefit from picking up assets at a lower price. But even if they’re wrong, they’ll have investments in the market as the price increases.
Hedging bets through volatility. DCA exposes investors to prices across time. When a market experiences price volatility, the goal of this strategy is to average out any dramatic increases or decreases in their portfolio and to benefit a little bit from price movement in every direction.
Avoiding FOMO and emotional trading. DCA is a rule-based approach to investing. Often, beginner traders fall into the trap of “emotional trading”, where buying and selling decisions are dictated by psychological factors like fear or excitement. These can lead investors to manage their portfolios ineffectively (think: panic selling during a downturn or overbetting due to fear of missing out on exponential growth).
How does DCA work in practice?
Of course, the success of any DCA plan is still dependent on market conditions. Let’s look at an example utilising real-world pricing as they neared Bitcoin’s greatest drop to yet. If you invested $100 in bitcoin every week beginning on December 18, 2017 (around the year’s price top), you would have invested $16,300 in total. However, your portfolio would be worth about $65,000 on January 25, 2021, representing a return on investment of more than 299 percent.
Going “all in” while prices are peaking, on the other hand, is typically regarded a terrible move – but how could you know? If you had invested the same $16,300 on December 18, 2017, you would have lost roughly $8,000 during the first two years. Although your portfolio will rebound, you would have missed out on the opportunity to multiply your earnings in the interim (and maybe even scared yourself into selling your bitcoin at a loss).
Assume you waited a year and invested $200 in bitcoin every month from December 2018 to December 2020. In this example, your portfolio would be little more than $13,000 in 2020, compared to $23,000 if you invested lump sum. This “all-in” investment would have yielded a larger reward, but it would also have been riskier, as any significant price swings after your initial investment date would have affected your whole investment.
Dollar-cost averaging is all about hedging your bets: it limits your potential gain to offset potential losses. It aims to decrease your risks of suffering severe losses to your portfolio as a result of short-term market volatility, making it a potentially safer alternative for investors.
To determine whether DCA is the best approach for you, consider your specific investing circumstances. Before embarking on a new investing plan, it is always advisable to get the advice of a financial specialist.