Dollar-cost averaging: Why is it crucial?

Important disclaimer: the information provided in this article is not intended to serve as financial advice and is just for informational purposes. You run the risk of having all of your money evaporate if the value of your digital assets goes down rather than up. Before deciding on any course of action regarding investments, you should always consult with an experienced advisor and carry out exhaustive research.

It is not surprising that one of the primary concerns of many people who invest in digital assets is volatility, given the significant price changes that have occurred over the course of the last several months. Because of the unpredictability of the markets, it might be tempting to try to timing allocations in order to maximize potential returns while preserving the portfolio from potential losses. However, years of experience have proven that market timing is almost never a successful investing strategy, and the ultimate result is typically the opposite of what is expected.

Instead, you might think about using the dollar-cost averaging method. The act of carefully dispersing comparable sums of money over equal intervals, such as once a month or once a week, is what is known as the dollar-cost averaging procedure.

There is no market timing aspect, and the effect of volatility is often reduced as a result. This is because the allocation amounts remain the same regardless of whether an asset is expensive or inexpensive. Using this method eliminates the need for emotional decision-making in asset management. When we, as human beings, try to pace the market, we let our emotional reactions play a role in our decision-making, which almost always results in us making a mistake, especially in the long run.

How does this really work when put into action?

To further illustrate the point, let’s look at a situation that really occurred. Take, for example, John and Katie, who are both investors in digital assets and who both put $5,000 into Bitcoin in 2018. John made the decision to invest the whole sum when the price of Bitcoin hit $13,800 on January 1, 2018, and he did so. This suggests that he held 0.362 BTC at one point.

On the other hand, Katie has the intention of making an investment of $500 per month for the next 10 months. Because she did not spend all of her money at once and was able to purchase Bitcoin at various prices during the ten months, she ended up with 0.61 Bitcoin at the end of the period. This was nearly twice as much as John had at the time.

Around the middle of the year 2021, the price of a single Bitcoin was close to $47,000. John’s profits would be around $17,000, for which he would get a return of 240 percent, or $12,000, on his initial investment of $5,000. On the other side, Katie has increased her initial investment of $5,000 to a total of $28,670, which is a return of 473 percent.

If you invest a big amount in digital currency at the beginning of this cycle, you will not be able to take advantage of the possibilities that have reduced barriers to entry later on in the cycle. This is quite easy to comprehend. On the other hand, making an attempt to anticipate these low-cost access points is a way that is both difficult and dangerous. The helpful graph on the right illustrates the price of Bitcoin between November 30, 2017, and December 1, 2020.

Advantages of Using the Dollar-Cost-Averaging Method

Using dollar-cost averaging may be beneficial in many different ways. To begin, it was said earlier that determining the ideal time to enter a market is sometimes beyond the capabilities of even the most seasoned investors since markets are difficult to foresee.

Second, using this approach will remove the need to manage your finances based on your feelings. When it comes to our own finances, as humans, we are prone to a number of biases, such as overconfidence and following trends, according to the behavioral finance theory. One of these biases is called the endowment effect. These biases may distort our understanding of how the market operates and cause us to join the market at the worst possible moment. This may be avoided by using dollar-cost averaging to spread out our investments over a longer period of time.

Third, the approach of dollar cost averaging makes wealth strategies more accessible to a larger portion of the general population. The majority of us do not have thousands of dollars lying around to put into digital assets as an investment. Despite this, it is not impossible to amass a sizeable holding and benefit from both the market’s highs and lows over the course of many months or even years.

Last but not least, in order to have some “dry powder” to stock up on digital assets when the market is doing poorly, it is best to invest just a little amount at regular intervals rather than putting all of your money in at once. For instance, if they had done so, they would have been able to capitalize on the recent decline in the price of Bitcoin. On April 14, the price of Bitcoin reached an all-time high of $64,804, but by July 21, it had fallen to a level below $30,000. Since that time, the price of bitcoin has increased by about 57 percent; hence, making allocations around the trough would have assisted in compensating for losses incurred as a result of allocations made at the peak in April.

Various circumstances

Profiting from your assets in a reliable and regular manner may often be accomplished via the use of the dollar-cost-averaging strategy. The market conditions in which we now find ourselves will, however, be the primary determinant of how successful it is. Think about it like this: you spend $10,000 on a coin or token worth $50, and in exchange, you get 200 tokens (all figures are sourced from nerwallet.com). The following chart provides an illustration of how the profit or loss on each transaction changes as a result of changes in pricing.

The dollar-cost-averaging strategy shows even more brightly in a market that is falling. Let’s say that over the course of a year, the $10,000 was spent in four separate transactions of equal value ($2,500 each), with token values of $50, $40, $30, and $25, respectively. This would result in the acquisition of a total of 295.8 tokens, and the following table provides an illustration of the profit or loss that would be incurred at different token values.

In a market that is considered to be flat, the profit or loss would be similar to that of an allocation of a lump amount when prices move the majority of the time horizontally. Nevertheless, there is always the possibility that prices may move rapidly, and this strategy is prepared to make the most of the situation if it does occur.

When prices are going up, dollar cost averaging is less enticing as a strategy to use. Let’s say we’re purchasing tokens with respective values of $50, $65, $70, and $80 and agreeing to pay a total of $10,000 for them. This would result in 155.4 tokens, and the payback profile would grow less attractive if prices continued to fall.

However, keep in mind that this circumstance of a continuously increasing market is not likely to result in a strategy that can be used to develop wealth over the long run. Because the prices of cryptocurrencies may change drastically within a matter of hours, trying to benefit from a bull market is a strategy that is both short-term and perilous. A method known as dollar-cost averaging presents an alternative that is more stable and, theoretically, less stressful for those who are interested in holding cryptocurrency for a lengthy period of time.

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