A basic investment strategy to get shielded from price volatility — DCA
Kudos to Gabriel Vazquez for the research and co-authoring.
What you need to know
- DCA is a strategy to hedge against volatility by spreading buys out over time.
- DCA is meant to remove the emotional side of investing by providing a patient, methodical approach.
- DCA works best over a long time period but results aren’t guaranteed.
- DCA is a good strategy for beginners or users seeking to invest with a smaller amount of funds.
Dollar-Cost Averaging (DCA) can be summed up in one sentence: “time in the market beats timing the market”. Whether you are a seasoned trader or a total newbie trying to find a way to grow your savings, DCA is a useful tool to maximize exposure to an asset while staying price-agnostic. Let’s explore what all this means.
DCA bases itself on a simple principle: cryptocurrency markets are notoriously volatile and timing them is extremely hard. Choosing a good entry and exit point, in other words, having good timing when exercising a buy or a sell, takes a lot of skill (or a lot of luck). This is no secret, it’s widely known that day traders (a term for investors who trade short-term movements in price) are mostly unsuccessful. Studies have shown that only around 5–20% of people who day trade end up being profitable. Almost everyone thinks they have a better understanding of the market but not many actually do. DCA (dollar-cost averaging) is a way around this.
Instead of watching the market, reading the news, looking at order books, studying indicators, gauging market sentiment through Fear and Greed indexes, and many other complexes and time-consuming methods people use DCA to guide their trading. DCA is a very simple strategy: buy on a schedule whatever the price.
At first, this may sound counterintuitive but, with a long enough time preference, it’s a strategy that tends to pay off. It is also a great strategy for beginners or those who are looking to invest but don’t have lots of funds. It’s important to note that this strategy works best when it is employed over the long term.
How it works
Let’s break down how DCA works by using an example (I’m going to use big round numbers to keep things simple). Say two friends, Juan and Pedro, each has $1,200 dollars to invest in Bitcoin. Let’s assume that today the price of Bitcoin is $50,000. Juan buys $1,200 at once and has .024 Bitcoin. Pedro decides to split his purchase into $100 per month, buying on the first of each month for the entire year. He commits to always buying regardless of what the price is. Let’s look at how Pedro’s purchases may look.
Disclaimer: we are using made-up prices for an example, your results may vary.
- In Jan, $100 at $50,000 = .0020 BTC
- In Feb, $100 at $60,000 = .0017 BTC
- In Mar, $100 at $65,000 = .0015 BTC
- In Apr, $100 at $50,000 = .0020 BTC
- In May, $100 at $40,000 = .0025 BTC
- In Jun, $100 at $35,000 = .0029 BTC
- In Jul, $100 at $40,000 = .0025 BTC
- In Aug, $100 at $30,000 = .0033 BTC
- In Sep, $100 at $35,000 = .0029 BTC
- In Oct, $100 at $40,000 = .0025 BTC
- In Nov, $100 at $45,000 = .0022 BTC
- In Dec, $100 at $50,000 = .0020 BTC
- $1,200 at $45,000 avg. = .028 BTC total
In this example, Pedro’s $1,200 dollars spread out over a year would purchase him a net of .028 BTC and his average price of buying would be $45,000. Juan’s BTC would still be worth $1,200 seeing as how Bitcoin returned to $50,000 at the end of the year. However, the .028 that Pedro stacked is worth $1,400: a 16% ROI (return on investment).
The Pros and Cons
As with any investment strategy, DCA has both pros and cons. You may have noticed that in the price examples in the table above, many months were spent at a lower price than the initial start of the experiment. This isn’t always the case. You can imagine a scenario where the price of Bitcoin, instead of dropping, has a great run and rises dramatically. In this scenario, DCA will get you a smaller amount of BTC than if you would have purchased it all at once.
However, there are no certainties in the crypto sphere, and dollar-cost averaging, in the long run, makes sense in many ways. For one, you don’t have all your eggs in one basket. Let’s say you make a lump-sum purchase at $50,000 and the price of Bitcoin falls dramatically to $25,000. Will you have the patience to HODL (hold on dear life — the act of buying and holding cryptocurrencies) and wait until the price goes back to what it was before? Will you be OK watching your initial investment worth half of what it once was? How long are you willing to wait? These are all emotional decisions you have to be ready to make. Investing, particularly in crypto, is very much an emotional trade. Strategies like DCA aim to take the emotion out of investing and instead rely on discipline, patience, and repetition.
An alternative scenario can be imagined where instead of DCA you want to wait to “get a better price”. You sit on the sidelines, money in hand, with a feeling in your gut that the price is going to turn favorably to you and you’re going to be able to time the bottom. But then it doesn’t dip, you haven’t bought at all and the price keeps getting higher. Or even worse, you FOMO (fear of missing out) all in when the price has already started to run-up. This is the meaning of “time in the market beats timing the market.”