Lump-sum or Dollar Cost Averaging for bitcoin?

Suppose you have a significant amount of money to invest in an asset of choice and you are not sure where the market might be heading in the near future. Should you just invest it all and hope for the best? Or is it better to gradually build your portfolio? Both options have their pros and cons, and choosing the right one can significantly impact your investing experience.

Perhaps the most common strategy is called either lump-sum or buy-and-hold, which, as its name suggests, involves deploying all your available capital at once and holding on to that position. It is a good way to reach a certain financial goal in the long run, but it does introduce a huge risk to a portfolio. Retail investors are notoriously ‘late to the party’. They often decide to take on exposure to an asset once it has already experienced significant upside. This increases the chances of buying a market top, resulting in a portfolio that quickly decreases in value, only turning a profit months or even years after the initial investment.

To solve the timing risk problem, some investors turn to another strategy: Dollar Cost Averaging, often referred to by the abbreviation DCA. This strategy calls for investing a fixed part of their savings with a predetermined frequency. It usually boils down to a monthly investment, but (bi-)weekly intervals are also common.

By definition, DCA decreases the speed at which an investor gains market exposure. So with DCA, investors avoid losses in downward moving markets as they have not yet invested all of their capital. But risk mitigation goes both ways. DCA investors miss out on upside in upward moving markets. This ultimately raises one crucial question: does the risk management in DCA outweigh its potential lack of returns?

A case study: bitcoin

In order to answer our research question, we turn our attention to one asset in particular: bitcoin. The logarithmically scaled price chart below clearly shows at which points in time a lump-sum strategy would have been a poor choice. Entering a position in late 2013, 2017 or 2021 would have resulted in a decrease in portfolio value of around 80%. And as it happens, these are exactly the times at which retail market participation is at its peak, often forming speculative bubbles.

Of course, this is only one side of the coin. Buying bitcoin during market bottoms in 2012, 2015 or 2019 would have resulted in huge upside for lump-sum, while DCA would have limited these profits by buying at higher prices after the market already bottomed out.

There is clearly a trade-off between the cautiousness of DCA and the return potential of lump-sum. But which of the two strategies is closest to the perfect balance? Before we jump to data analysis, we must note that the optimal combination depends on each individual’s risk appetite. If one is not bothered by any portfolio fluctuations and has a long enough investment horizon, lump-sum would have been optimal most of the time. But being caught off-guard by huge price drops can have massive repercussions if one is forced to exit a position before the market turns in their favour.

In our research, we will use two well-known and simple measures to gauge the effectiveness of DCA on risk management and how decreased risk relates to overall portfolio performance:

1. Maximum drawdown: the largest observed drop that a portfolio experienced in a given time frame. It yields an approximation for the worst-case scenario for that period. For instance, if the maximum value of bitcoin was $40k in 2022, and decreases to a minimum value of $20k afterwards, the maximum drawdown in that year is -50%.
2. Calmar ratio: the average portfolio return relative to the maximum drawdown. If one portfolio has a higher Calmar ratio than another portfolio, it means that it has a better risk-return performance.

Let’s apply some backtesting and find out how the lump-sum and both monthly and weekly DCA strategies have performed in the past ten years. The backtest details and results summary can be found in the Appendix.

Results

We start off with the most straightforward performance metric: the actual returns per year for each strategy. These returns are measured from the start to the end of the year and give us insights into whether it is profitable to deploy cash all at once (lump-sum) or gradually (DCA).

In the figure below, lump-sum generally shows more extreme returns, both in positive and negative directions. Especially the returns in 2013 are exceptional (lump-sum returns are over 5,400% and are not fully included in the plot for the sake of readability). The average annual returns are over three times higher than those of the DCA strategies.

We know that returns do not paint a strategy’s full picture, so we also need to consider risk measures such as the maximum drawdown. The figure below shows the results for each individual year since 2012. We notice that lump-sum has larger drawdowns and is consistently riskier than DCA. Especially in years with extreme crashes (like COVID in March 2020), the difference in drawdown is quite substantial. On average, the lump-sum portfolio drops around 20% more from top to bottom. And between the two DCA strategies, the weekly DCA appears to be the least risky.

But what does the limited downside risk of DCA tell us about the overall portfolio performance? Putting the returns and maximum drawdowns into a single equation gives us the Calmar ratio. This ratio shows very large fluctuations across all the years in our sample period. Sometimes the DCA strategies outperform lump-sum and sometimes it is the other way around. But on average, the Calmar ratio is practically identical for all three strategies. In other words, all strategies show similar performance if we adjust for the level of risk.

Conclusion

In this article, we analysed the performance of two retail investment strategies: lump-sum and Dollar Cost Averaging (DCA). The latter mitigates the timing risk of the former, but also potentially limits profits in an upward moving market. The results show that DCA consistently lowers maximum drawdowns in bitcoin-only portfolios, while keeping the overall performance equal to that of a lump-sum strategy. This leads to the conclusion that DCA is a suitable solution for careful investors that seek to manage the risk in their portfolio while still gaining exposure to a volatile asset class such as crypto.

In the end, investors should consider their risk tolerance and investment goals before choosing what strategy they are most comfortable with. But the effort to buy an safely store bitcoin on a regular basis can also play an important role in this decision. At Amdax, we try to lower the threshold to opt for a DCA strategy by providing a ready-to-use savings plan.

Appendix

Backtest details

• The total amount of investable capital is assumed equal for all strategies.
• We assume a fixed transaction fee rate at 0.7% per transaction and fixed custody fee at 0.6% per year.
• We assume an annual risk-free rate equal to the 4-week T-bill rate.

Results summary