Cryptocurrencies like Bitcoin can experience daily (or even hourly) price volatility. As with any kind of investment, volatility may cause uncertainty, fear of missing out, or fear of participating at all. When prices are fluctuating, how do you know when to buy?
In an ideal world, it’s simple: buy low, sell high. In reality, this is easier said than done, even for experts. Instead of trying to “time the market,” many investors use a strategy called dollar-cost averaging (or “DCA”) to reduce the impact of market volatility by investing a smaller amount into an asset — like crypto, stocks, or gold — on a regular schedule.
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 strategy, where an investor regularly buys smaller amounts of an asset over a period of time, no matter the price (for example, investing $100 in Bitcoin every month for a year, instead of $1,200 at once). Their DCA schedule may change over time and — depending on their goals — it can last just a few months or many years.
Although DCA is a popular way to buy Bitcoin, it isn’t unique to crypto — traditional investors have been using this strategy for decades to weather stock market volatility. You may even use DCA already if you invest via your employer’s retirement plan every payday.
What are the benefits of DCA?
DCA can be an effective way to own crypto without the notoriously difficult work of timing the market or the risk of unwittingly using all of your funds to invest “a lump sum” at a peak.
The key is choosing an amount that’s affordable and investing regularly, no matter the price of an asset. This has the potential to “average” out the cost of purchases over time and reduce the overall impact of a sudden drop in prices on any given purchase. And if prices do fall, DCA investors can continue to buy, as scheduled, with the potential to earn returns as prices recover.
When is DCA more effective than lump-sum investing?
DCA can help an investor safely enter a market, start benefiting from long-term price appreciation, and average out the risk of downward price movements in the short-term. And in situations like the ones below, it may offer more predictable returns than investing a lot of cash 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 strategy is still subject to what’s happening in the market. To demonstrate, let’s dig into an example using real-world prices, right as they approached Bitcoin’s biggest downturn to date. If you invested $100 in bitcoin every week starting on December 18, 2017 (near that year’s price peak), you would have invested a total of $16,300. But on January 25, 2021, your portfolio would be worth approximately $65,000 — a return on investment of more than 299%.
In contrast, going “all in” as prices are peaking is generally considered a bad idea — but how could you know? If you had taken that same amount of $16,300 and invested it all on December 18, 2017, you would lose nearly $8,000 throughout the first two years. Although your portfolio would recover, you would have lost out on the ability to compound your profits in the meantime (and maybe even scared yourself into selling your bitcoin at a loss).
Now let’s say you waited a year, and invested $200 in bitcoin every month between December 2018 and December 2020. In this case, your portfolio would total just over $13,000 in 2020, compared to $23,000 from investing lump-sum. This “all-in” investment would have earned you a higher profit, but it also would have been riskier: any significant price movements after your initial investment date would have affected your whole investment.
Dollar-cost averaging is all about hedging your bets: it restricts your potential upside in an effort to mitigate possible losses. Serving as a potentially safer choice for investors, it works to reduce your chances of taking serious hits to your portfolio caused by short-term price volatility.
To know if DCA is the right strategy for you, it’s important to think about your unique investment circumstances. It is always best to consult a financial professional before undertaking a new investment strategy.
Sourced from Coinbase.com.