Cryptocurrencies such asBitcoinThey can be characterized by high daily (and even hourly) price volatility. As with any type of investment, volatility can lead to uncertainty, FOMO (fear of missing out) syndrome, or fear of participation. When prices fluctuate, how do you know when to buy? In an ideal world, it’s simple: buy low, sell high. In practice, even with experts, this is easier said than done. Instead of trying to “time the market,” many investors use a strategy calleddollar-cost averaging. The goal of this strategy is to reduce the impact of market volatility by investing smaller amounts in assets such as cryptocurrencies, stocks, or gold on a regular schedule.
What is dollar-cost averaging?
Dollar-cost averaging can be the right choice when someone believes that their investments will strengthen (or increase in value) over the long term, and there may be price fluctuations along the way.
Dollar-cost averaging (DCA) is a long-term strategy in which an investor regularly buys smaller amounts of assets over a period of time, regardless of price (for example, investing $100 inBitcoinevery month for a year, instead of $1200 at a time). The DCA timeline can change over time and, depending on the objectives, may only cover a few months or many years.
Dollar-cost averaging is a popular investment strategy used when buying bitcoin. However, this method is not unique to cryptocurrencies – traditional investors have been using it for decades to cope with stock market fluctuations. It’s possible that you’re already using this strategy if you regularly invest in your employer’s retirement plan with every paycheck.
What are the benefits of dollar-cost averaging?
Dollar-cost averaging can be an effective way to hold cryptocurrencies without the extremely difficult art of timing the market or the risk of recklessly using all of your funds to invest a larger amount at once when the price peaks.
It is crucial to determine a safe amount and invest regularly, no matter the price of the asset. This can potentially “average” the cost of a purchase over time and reduce the overall impact of a sudden drop in prices on a given purchase. And if prices fall, traders using this strategy can continue to buy with the plan, earning potential profits as prices rise.
When is dollar-cost averaging more effective than investing larger amounts at once?
Dollar-cost averaging can help a trader enter the market safely, start to benefit from long-term price increases, and average out the risk of price declines in the short term. And in situations like the ones below, it can offer more predictable returns than investing a lot of cash in one go:
Buying an asset that may increase in value over time. If an investor believes that prices will fall but are likely to return to normal in the long term, they can use dollar-cost averaging to invest cash over a period where they think a downward move will occur. If he is right, he will benefit from acquiring the asset at a lower price. And even if he is wrong, he will have investments in the market, waiting for prices to rise.
Hedging positions against volatility. The purchase cost averaging strategy makes the investor have exposure to prices over time. When there is price volatility in the market, the job of this strategy is to average out any drastic increases or decreases in the portfolio and derive little benefit from the price movement in each direction.
Avoiding FOMO and emotion-driven trades. Dollar-cost averaging is a principled approach to investing. Often, novice traders fall into the trap of making trades under the influence of emotions, where buying and selling decisions are dictated by psychological factors such as fear or excitement. This can cause investors to manage their portfolios inefficiently (for example: panic selling when prices are falling or over-investing due to fear of missing out on opportunities).
How does dollar-cost averaging work in practice?
Of course, the success of any DCA application depends on what is happening in the market. To demonstrate this, let’s analyze an example using real-world prices, at the exact moment when they were approaching the biggest drop in bitcoin prices to date. If someone invested $100 in bitcoin every week, starting on December 18, 2017 (around the yearly price peak), they would have invested a total of $16,300. This would put the value of such a portfolio around $65,000 on January 25, 2021, representing a return on investment of over 299%.
On the other hand, going “all in” when prices are peaking is generally considered a bad idea – but how can you know that? Investing the same amount of $16,300 in full on December 18, 2017, the loss would have been almost $8,000 in the first two years. Although the portfolio would regain its value, the opportunity to multiply profits would be lost during this time (and maybe even fear would make the investor sell bitcoins at a loss).
Now, let’s assume that an investor waited a year and invested $200 in bitcoin every month from December 2018 to December 2020. In this case, the value of yours would be just over $13,000 in 2020, compared to $23,000 for a one-time investment. This investment of all funds would yield a higher profit, but it would also be riskier – any significant price movements after the start date of the investment would affect its total value.