What is dollar cost averaging and why does it matter?
IMPORTANT NOTICE: This article does not constitute financial advice and is for informational purposes only. The price of digital assets can go down as well as up and you may lose all of your capital. You should always consult a professional advisor before making any investment decisions.
One of the main concerns for many people allocating to digital assets is volatility, which is understandable given the fluctuations we have seen in prices in recent months. When markets are so volatile, it can be tempting to try timing one’s allocations to make the most of the upside and protect the portfolio on the downside. However, practice shows that market timing is not an efficient way to invest and the result is usually the opposite of what one wants to achieve.
Instead, it could be a good idea to consider dollar cost averaging. In the simplest terms, dollar cost averaging is the practice of systematically allocating equal amounts of money spaced out over equal time periods: for example, once a month or once a week.
This strategy takes the emotional element out of managing one's assets. As humans, when we try to time the market, we allow our emotional response to get involved, which leads to us almost always getting it wrong, especially in the long run. Allocating the same amount regularly means there is no market timing element, while the effect of volatility is typically reduced because allocation amounts are equal whether an asset is cheap or expensive.
How does this work in real life?
Let’s look at a real-life example so this makes a little more sense. Let’s compare two digital asset users - John and Katie - who both deployed $5,000 in Bitcoin in 2018. John decided to allocate the whole sum on January 1, 2018, when the price of Bitcoin was $13,800 (according to Dollar Cost Averaging Bitcoin - dcaBTC). This means he owns 0.362 BTC.
Katie, on the other hand, decides to deploy $500 a month for 10 months. At the end of this period, she finds herself with 0.61 BTC - nearly twice as much as John - simply because she did not deploy all her money at the same time and was able to capture BTC at different prices throughout the 10-month period (all figures sourced from dcabtc.com).
With Bitcoin currently trading close to $47,000 (as of August 26, 2021), John would today have around $17,000, having made a $12,000 return on his $5,000 allocation, or 240%. Katie, however, now has $28,670, a return of 473% on her initial allocation of $5,000!
This handy graph shows Bitcoin prices between Nov 30, 2017, and December 1, 2020. It is easy to see that putting a lump sum into the digital currency at the beginning of this cycle would mean losing out on the cheaper entry points throughout the period. Trying to predict these cheap entry points, however, is a tricky and risky strategy.
Advantages of dollar cost averaging
Dollar-cost averaging has a number of benefits. Firstly, as we have mentioned, finding the right entry point is typically beyond even the most experienced of investors, because markets are hard to predict.
Secondly, this approach removes the emotional element from money management. Behavioural finance theory stipulates that there are many biases to which we as humans are susceptible when it comes to our own wealth, including overconfidence and chasing trends. These biases can distort our understanding of how the market functions and drive us to get in at the worst of times, which can be avoided through dollar cost averaging.
Thirdly, the dollar cost averaging approach makes wealth strategies widely available to a larger demographic. Many of us don’t have thousands of dollars to deploy in digital assets straight away, but over months or even years, it is possible to build a significant holding and make the most of the tops and bottoms of the market.
And finally, allocating a smaller amount at regular intervals rather than going all in straight away leaves one with some dry powder to stock up on a digital asset when the price crashes. For example, it would have made it possible to take advantage of the recent crash in the price of Bitcoin, which fell from its all-time high of $64,804 on April 14 to trade below $30,000 on July 21. Since then BTC has soared again by around 57%, so allocating close to the trough would have helped to offset losses from allocations made close to the peak in April.
The dollar cost averaging strategy is typically a safe and steady way to earn on your assets. However, its efficiency does depend on the market conditions we find ourselves in. Let’s look at an example of buying $10,000 worth of a $50 coin or token, netting 200 tokens (all figures are sourced from nerwallet.com). The chart below shows the profit or loss on each trade if the price goes up or down.
In a falling market, the dollar cost averaging strategy truly shines. Let’s say the $10,000 was split equally among four purchases ($2,500 each) at token prices of $50, $40, $30 and $25 over the course of a year. In total, this would buy 295.8 tokens and the table below shows the profit/loss at different sell prices.
In a flat market, where prices are mostly going sideways, the profit/loss scenario would look very similar to a lump sum allocation. However, there is always the possibility that prices will fluctuate significantly and this strategy is poised to take advantage if this happens.
In a rising market, dollar cost averaging looks less attractive. Let’s assume we’re spending $10,000 in four installments on tokens priced $50, $65, $70 and $80, respectively. This would result in the purchase of 155.4 tokens and, as prices fall, the payoff profile looks less favorable.
However, keep in mind that for long-term wealth accumulation strategies, this scenario - i.e. a consistently rising market - is unlikely to last for a long time. In the world of cryptocurrencies, prices can fluctuate significantly in a matter of days, so trying to capture the upside in a bull market is a short-term and risky strategy. For those wanting to hold crypto for a long time, a dollar cost averaging strategy provides a steadier, potentially less stressful alternative.