Dollar cost averaging (DCA) is an investment strategy used to reduce a portfolio’s volatility exposure. To dollar cost average, investors divide a lump sum into several smaller portions then invest them periodically regardless of asset price.
Dollar Cost Averaging and Crypto: How does it work?
For instance, to invest $12,000 in Bitcoin over one year, you would invest $1,000 per month into Bitcoin for 12 months. The monthly investment amount does not change regardless of Bitcoin price movement over the course of the year.
The number of shares/coins owned at the end of this cycle depends on the asset’s price performance. If prices dip from the initial price point, more shares are accumulated for cheap whereas fewer shares will be bought if prices rise. Theoretically, dollar cost averaging allows investors to balance returns by averaging out the overall cost paid per share. Investors no longer have pressure to try and time the market.
How does dollar cost averaging reduce risk?
Dollar cost averaging is useful for:
- Eliminating the stress and effort of ‘timing the market.’
- Reducing risk because you don’t invest all your funds at once at a single price point.
- Providing risk-averse beginners a valid investment strategy to evaluate the market.
Note that DCA does not eliminate the potential for investment risks or loss. It helps reduce risk but is also less likely to net outsized returns.
Boris purchases 40 shares at $10 all at once. Abby uses DCA to invest $100 in 4 separate increments. As the share price fluctuates, her incremental investment amount doesn’t change. (Source: Spaugh Dameron Tenny)
Is Dollar Cost Averaging a Good Idea for Crypto?
Unlike traditional securities markets, cryptocurrencies are relatively new and can experience extreme volatility. Even experts hesitate to predict crypto price trends. However, dollar cost averaging can slash a significant amount of risk associated with such unpredictable markets.
DCA limits losses when digital currency markets crash, but also hinders returns when these markets boom. Since many investors prioritize reducing losses when entering volatile markets, DCA is a valid strategy for cryptocurrency investing.
What Are the Benefits of Dollar-Cost Averaging?
- Low incremental cost: DCA lowers the incremental cost of investment by averaging out the asset’s price over a broad time frame. You can accumulate a large chunk of shares for cheap during bear markets to make up for fewer purchases during bull markets.
- Risk reduction: DCA is generally a safer strategy of investment because some capital is preserved for increased flexibility and liquidity.
- Stress management: DCA allows you to remain stress-free and consistent with your investments by flattening the volatility of returns.
- Avoid bad market timing: By adopting multiple price points, you can avoid poor timings caused by ineffective market analysis, emotional influence, or bad luck.
What are the Drawbacks of Dollar-Cost Averaging?
- Higher transaction fees: Transaction costs may add up as you regularly purchase securities over a long time frame.
- Lower risks come with smaller rewards: While DCA helps spread out a buy-in price to minimize losses, it can be a drag on overall profitability. The stock market historically experiences rising prices over the long term, so DCA investors may lose out on asset appreciation compared to lump sum investors.
- Doesn’t make up for bad investments: DCA won’t help an investment grow. If the market doesn’t fundamentally value an asset, its long-term investment value won’t improve through dollar cost averaging.
DCA vs Other Investment Strategies
DCA vs. Lump Sum Investing
This is a simple yet demanding strategy. You first evaluate risks, returns, price performance, and other indicators. Then, after making a decision, you release all of your money at once into the market. This may seem risky, but historical data has shown that lump sum investing into well-performing securities can generate very strong returns in the long-term. In fact, a 2012 study published by Vanguard found that over 10-year periods, lump sum investing actually beat out dollar cost averaging around two-thirds of the time in the U.S., U.K., and Australian markets .
Historical Data on Lump Sum Investing vs DCA
DCA can lower both your losses and rewards. The above data serves as a good example. Source: YouTube (Channel: Bitcoin for Beginners)
DCA vs. Value Averaging (VA)
Value averaging occurs when one buys an asset at regular intervals for a certain amount of time. This may sound similar to DCA, but there is a fundamental difference. The amount invested varies for each cycle, depending on overall portfolio performance. If the portfolio value rises, the investment amount decreases. If the portfolio value falls, the investment amount increases.
The core principle of VA is to buy the dip of long-term well-performing assets. This strategy is not as simple as it seems. It requires research and knowledge of the securities being purchased. Investors should be confident that these securities will appreciate in the long-term so that “buying the dip” will likely net higher returns.
In a sense, VA gives investors more flexibility compared to DCA because investment amounts can be adjusted regardless of the stats. Ultimately, the VA strategy will only work as well as one’s ability to read and analyze the market.
Should You Use Dollar Cost Averaging?
If you enjoy taking a hands-on approach to investing and often spend significant time researching the market, lump-sum investing might allow you to reap huge rewards. Dollar cost averaging will flatten the ratio of your risks and rewards.
On the other hand, if you prefer a more hands-off approach and want to take emotions out of investing, dollar cost averaging is for you! It has proven to lower investment risks and stress levels. It’s also great if you are a beginner trying to ease into the market or if you want to limit losses in unpredictable markets like cryptocurrencies.