What is dollar-cost averaging?
The premise is that by entering the 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 over your investment. Let’s see how DCA works and why you might want to consider using it.
Why use dollar-cost averaging?
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.
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.
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.
Dollar-cost averaging example
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.
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
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.
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.