Dollar-Cost Averaging (DCA) Explained
Introduction
Active trading can be stressful, time-consuming, and still yield poor results. However, there are other options out there. Like many investors, you might be looking for an investment strategy that is less demanding and time-consuming. Or just a more passive investment style.
But what if you want to invest in the markets but don’t really know how to start? More specifically, what would be the optimal way to build a longer-term position? In this article, we’ll discuss an investing strategy known as DCA, or dollar-cost averaging, which provides an easy way to mitigate some of the risks of entering a position.
What is dollar-cost averaging?
Dollar-cost averaging is an investment strategy that aims to reduce the impact of volatility on the purchase of assets. It involves buying equal fiat amounts of the asset at regular intervals.
The premise is that by entering a market like this, the investment may not be as subject to volatility as if it were a lump sum (i.e., a single payment). How so? Well, buying at regular intervals can smooth out the average price. In the long term, such a strategy reduces the negative impact that a bad entry may have on your investment. Let’s see how DCA works and why you might want to consider using it.
Why use dollar-cost averaging?
The main benefit of dollar-cost averaging is that it reduces the risk of making a bet at the wrong time. Market timing is among the hardest things to do when it comes to trading or investing. Often, even if the direction of a trade idea is correct, the timing might be off – which makes the entire trade incorrect. Dollar-cost averaging helps mitigate this risk.
If you divide your investment up into smaller chunks, you’ll likely have better results than if you were investing the same amount of money in one large chunk. Making a purchase that’s poorly timed is surprisingly easy, and it can lead to less than ideal results. What’s more, you can eliminate some biases from your decision-making. Once you commit to dollar-cost averaging, the strategy will make the decisions for you.
Dollar-cost averaging, of course, doesn’t completely mitigate risk. The idea is only to smooth the entry into the market so that the risk of bad timing is minimized. Dollar-cost averaging absolutely won’t guarantee a successful investment – other factors must be taken into consideration as well.
As we’ve discussed, timing the market is extremely difficult. Even the biggest trading veterans struggle to accurately read the market at times. As such, if you have dollar-cost averaged into a position, you might also need to consider your exit plan. That is, a trading strategy for getting out of the position.
Now, if you’ve determined a target price (or price range), this can be fairly straightforward. You, again, divide up your investment into equal chunks and start selling them once the market is closing in on the target. This way, you can mitigate the risk of not getting out at the right time. However, this is all completely up to your individual trading system.
Some people adopt a “buy and hold” strategy, where essentially the goal is to never sell, as the purchased assets are expected to continually appreciate over time. Take a look at the performance of the Dow Jones Industrial Average in the last century below.
Performance of the Dow Jones Industrial Average (DJIA) since 1915.
While there are short-term periods of recession, the Dow has been in a continual uptrend. The purpose of a buy and hold strategy is to enter the market and stay in the position long enough so that the timing doesn’t matter.
However, it’s worth keeping in mind that this kind of strategy is usually geared towards the stock market and may not apply to the cryptocurrency markets. Bear in mind that the performance of the Dow is tied to a real-world economy. Other asset classes will perform very differently.
Dollar-cost averaging example
Let’s look at this strategy through an example. Let’s say we’ve got a fixed dollar amount of $10,000, and we think it’s a reasonable bet to invest in Bitcoin. We think that the price will likely range in the current zone, and it’s a favorable place to accumulate and build a position using a DCA strategy.
We could divide the $10,000 up into 100 chunks of $100. Each day, we’re going to buy $100 worth of Bitcoin, no matter what the price. This way, we’re going to spread out our entry to a period of about three months.
Now, let’s demonstrate the flexibility of dollar-cost averaging with a different game plan. Let’s say Bitcoin has just entered a bear market, and we don’t expect a prolonged bull trend for at least another two years. But, we do expect a bull trend eventually, and we’d like to prepare in advance.
Should we use the same strategy? Probably not. This investment portfolio has a much larger time horizon. We’d have to be prepared that this $10,000 will be allocated for this strategy for another few years. So, what should we go for?
We could divide the investment into 100 chunks of $100 again. However, this time, we’re going to buy $100 worth of Bitcoin each week. There are more or less 52 weeks in a year, so the entire strategy will execute over a little less than two years.
This way, we’ll build up a long-term position while the downtrend runs its course. We’re not going to miss the train when the uptrend starts, and we have also mitigated some of the risks of buying in a downtrend.
But keep in mind that this strategy can be risky – we’d be buying in a downtrend after all. For some investors, it could be better to wait until the end of the downtrend is confirmed and start entering then. If they wait it out, the average cost (or share price) will probably be higher, but a lot of the downside risk is mitigated in return.
Dollar-cost averaging calculator
You can find a neat dollar-cost averaging calculator for Bitcoin on dcabtc.com. You can specify the amount, the time horizon, the intervals, and get an idea of how different strategies would have performed over time. You’ll find that in the case of Bitcoin, which is in a sustained uptrend over the long-term, the strategy would have been consistently working quite well.
Below, you can see the performance of your investment if you’ve bought just $10 worth of Bitcoin every week for the last five years. $10 a week doesn’t seem that much, doesn’t it? Well, as of April 2020, you would’ve invested in total about $2600, and your stack of bitcoins would be worth about $20,000.
Performance of buying $10 of BTC every week for the last five years. Source: dcabtc.com
The case against dollar-cost averaging
While dollar-cost averaging can be a lucrative strategy, it does have its skeptics as well. It undoubtedly performs best when the markets experience big swings. This makes sense, as the strategy is designed to mitigate the effects of high volatility on a position.
According to some, however, it’ll actually make investors lose out on gains when the market is performing well. How so? If the market is in a sustained bull trend, the assumption can be made that those who invest earlier will get better results. This way, dollar-cost averaging can have a dampening effect on gains in an uptrend. In this case, lump sum investing may outperform dollar-cost averaging.
Even so, most investors don’t have a large chunk available to invest in one go. However, they may be able to invest small amounts over the long-term – dollar-cost averaging can still be a suitable strategy in this case.
Closing thoughts
Dollar-cost averaging is a redeemed strategy for entering into a position while minimizing the effects of volatility on the investment. It involves dividing up the investment into smaller chunks and buying at regular intervals.
The main benefit of using this strategy is the following. Timing the market is difficult, and those who don’t wish to actively keep track of the markets can still invest this way.
However, according to some skeptics, dollar-cost averaging can make some investors lose out on gains during bull markets. With that said, losing out on some gains isn’t the end of the world – dollar-cost averaging still can be a convenient investment strategy for many.