To mitigate this problem, many investors and traders use the so-called dollar-cost averaging (DCA) investment strategy. With dollar-cost averaging, the investor periodically buys an amount of crypto corresponding to a fixed amount of fiat – for instance buying $1000-worth of BTC each month. But does this strategy actually pay off and what are the alternatives?
DOLLAR-COST AVERAGING ESSENTIALS:
- Dollar-cost averaging (DCA) is a common investment strategy.
- It involves periodic investments of fixed amounts of fiat.
- Instead of investing $10,000 in a one-off purchase and risking a sudden drop in the purchased asset’s value, you could make ten investments of $1000.
- This mitigates the risk of significant losses.
- DCA is an effective strategy for those who wish to build their crypto portfolio gradually.
The fundamentals of dollar-cost averaging
Dollar-cost averaging simply refers to an investment strategy where you invest a fixed amount of fiat currency periodically. So instead of making one hefty investment and risking the market crashing right after you make your investment, you could make smaller periodic investments and mitigate that risk.
Let’s say you have $10,000 set aside, which you can afford to invest in crypto. You could make a one-off investment, putting the total sum of your savings into bitcoin. However, you would have to time the investment to make sure that you weren’t taking on too much risk. The market could crash during the following week or month, in which case you’d be left with significantly less money from your initial investment.
It may be wiser to divide your saved money into 10 smaller monthly investments of $1,000 each. Although this technique does not necessarily ensure a better return on investment, it would definitely mitigate the risk of short and medium-term market conditions. Some of these investments would most likely be made in uptrends, while others would be made in downtrends. However, it is still best to utilize technical analysis and fundamental analysis to ensure you do not start dollar-cost-averaging at the beginning of a long-term downtrend.
Mitigating the risk of investing before a market crash is just one of the advantages of dollar-cost averaging. Other benefits include:
- It eliminates the gamble with timing and minimizes over-emotional investment;
- It helps you gradually build your portfolio, hence motivating you to maintain interest;
- It smooths out the impact of short-term volatility.
Is DCA an effective strategy?
The aforementioned advantages are promising, but there are a couple of drawbacks when it comes to dollar-cost averaging. The first one is that investing all at once can result in better returns, mainly because your assets are in the market for a longer period of time. This is based on the idea that the longer your assets are in the market, the better your returns are in the long run.
Perhaps the best-known alternative to dollar-cost averaging is buying the dip. Let’s say you decided to try out dollar-cost averaging for two years, investing $100 per month in BTC. This means you would invest a total of $2,400 over a period of two years. In this time, the BTC price would fluctuate, so you would probably make a couple of suboptimal $100 installment investments when the price was high. Instead of the dollar-cost averaging approach, you could also have placed $100 in your savings account each month. Then, if you monitored the BTC market and did your technical analysis, you could potentially predict when the market has hit a bottom. This approach could enable you to buy BTC at an optimal price.
In the scenario we’ve described, you have been saving up $100 per month for seven months, and you notice that the price of BTC is at its lowest point over the last year. If you are convinced that the price of BTC will not go further down, the best idea would be to use the $700 that you have been saving to buy a corresponding amount of BTC. Then you could start over by saving $100 per month until the next dip in price.
But buying the dip is tricky because one can never be absolutely positive that the price will not go further down. You would have to time your purchase exceptionally well to buy an asset at the bottom – right before the start of a bull market.
If you are not confident about your investment timing, wish to reduce the overall risks of your investment or do not want to spend too much time analyzing the market, then perhaps dollar-cost averaging would be a wise option. This simple, long-period investment method is suitable for nearly everyone.