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What You Should Know About Dollar-Cost Averaging

18 August 2022

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What You Should Know About Dollar-Cost Averaging
What is Dollar Cost Averaging? / The Benefits of Dollar Cost Averaging / The Downsides of Dollar Cost Averaging / Why It Can Be Well-Suited Toward Crypto Markets / The Bottom Line / A Parting Analogy / 

In times of high volatility, dollar-cost averaging can be a helpful technique when investing. Learn more about what it is, how to do it, and why it's especially useful for crypto markets.

What is Dollar Cost Averaging?

The strategy works like this: instead of making one big investment at a predetermined price, you make equal dollar investments at set intervals. So if the price drops, your average cost (e.g., per share or per Bitcoin purchase) is lower than it would be otherwise. If the price goes up, your average cost would be higher than it would be otherwise.

For example, say you have $10,000 that you would like to invest in stocks. You could buy all at once (called lump-sum investing), but that would expose you to bigger market fluctuations. Markets are unpredictable, so even if you think you're buying at a good price, it could drop even further, leaving you sitting on losses. Of course, you could get lucky and buy at a local low, but things could also go the other way.

If you were to dollar-cost average, you'd divide your $10,000 evenly into ten equal parts ($1,000 each) and invest at predetermined times like once a month or once a quarter. This way you're buying in at 10 different prices and averaging out your cost per share. Some purchases might be higher than your initial entry and some might be lower.

The Benefits of Dollar Cost Averaging

Like most investment strategies, dollar-cost averaging has its pros and cons. Let's start with the pros.

#1—Saves you from your emotions

Investing is emotional. Most of us don't want to be in the market when prices are low but we don't want to miss out on an opportunity if the market takes off. With dollar-cost averaging, you don't have to worry about getting in at a good price or missing out on a rally; it opens your exposure to both.

#2—It's just easier

Investing is hard. DCA-ing takes out the guesswork. Most people would agree that they want to be better investors. Or at the very least, they want to save their money and watch it grow. Dollar-cost averaging doesn't require complex calculations or a ton of research. It's simple and doesn't require much of a time commitment. In fact, many banks and brokerages allow you to "set it and forget it" with automatic investment programs that will DCA for you.

#3—It's a good way to get started if you don't have a lot of money

If you have a small amount of money or if you're just getting your feet wet with investing, dollar-cost averaging helps you build a position over time. You can add to your investment as money becomes available, rather than trying to make one big investment that could be too much for you to handle emotionally.

#4—It's a good way to diversify across sectors

Dollar-cost averaging is one of the most effective ways to mix up your investments. If you invest all of your money in one, highly volatile sector, it's not a very diversified portfolio. DCA-ing across different sectors or asset classes will help balance things out so you're not overly exposed to any one sector. Let's say you want to invest in tech stocks, pharmaceutical stocks, and industrial stocks. You could DCA in three equal portions, alternating between each sector every month (e.g., January in tech, February in pharma, March in industrial; repeating this pattern).

The Downsides of Dollar Cost Averaging

While dollar-cost averaging has its benefits, it has some downsides.

#1—It doesn't guarantee a profit

DCA-ing will put you in a well-diversified portfolio, but that doesn't mean that it's going to make money. Volatility can be your friend or your enemy. Being diversified can help you ride out the storms, but it won't guarantee a profit.

#2—It requires discipline

With dollar-cost averaging, you're committing to an investment plan and sticking with it no matter what happens in the market. That means if Bitcoin falls 50% after you put in $1000, and the price drops, that's $500 you'll have to deal with watching fall. Depending on how much pain that brings to you, this could be tough to stomach if Bitcoin continues dropping for several months at a time. That said if you're able to ride it out, you could come out ahead when the next bull run starts.

#3—It requires patience

DCA-ing is a long-term strategy. You're not going to get rich quick by dollar-cost averaging. You need to be patient and have a time horizon of years, not weeks or months. Dollar cost averaging can be a great way to build your portfolio over time, but because you're working with a smaller amount of money each month, it will take longer to reach your goals.

Why It Can Be Well-Suited Toward Crypto Markets

Crypto markets are extremely volatile and unpredictable, significantly moreso than most traditional markets. Furthermore, crypto markets are still relatively small, which means that it's highly susceptible to outside influences. Events like geopolitical tensions, regulatory changes, and hacks can cause the value of a cryptocurrency to fluctuate wildly in a short period of time. Dollar-cost averaging helps dull this volatility.

The Bottom Line

Dollar-cost averaging is not a magic bullet for investing success. It's just one tool in an investor's toolkit. But it has the potential to help you build your portfolio over time and manage your emotions around investing.

A Parting Analogy

DCA-ing is like exercising with a dumbbell. You work out the same muscle group here and there. You'll get a little faster and stronger over time, but it's going to take some time before you can see progress. You can't just work out for 6 hours and expect to see results quicker. In fact, your body will break down if you overdo it.

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