What is dollar-cost averaging?
Dollar-cost averaging is a simple but powerful investing strategy that’s designed to protect you from volatility (big price swings). It works like this: Rather than making a single large purchase all at once, you instead make several smaller purchases over time.
On the positive side, this strategy can protect you from “buying the top.” This refers to the fact that markets are inevitably cyclical, with peaks and troughs over time. Everyone wants to buy low and sell high, but the problem is that it can be extremely difficult to know, at any given time, whether you’re in a peak or a trough. After all, what looks like a peak now, may in fact only be the start of a much larger rise. Conversely, what appears to be the bottom, may in fact be just the beginning of a much bigger drop. For example, looking at the following chart, you might think the point marked with the star is the bottom:
But when you zoom out, you can see that price ended up dropping much lower over the following months:
On the negative side, dollar-cost averaging may result in less profit than you’d otherwise realize, assuming you managed to “buy the bottom.” For this reason, dollar-cost averaging is essentially a "less risk, less reward" investing strategy.
To illustrate the advantages and disadvantages of dollar-cost averaging in practice, let's look at two examples:
Example 1: “Buying the top”
Here we start with an initial purchase on January 1, 2018, and consider a two-year time frame.
Bitcoin price at purchase: $13,657
Bitcoin price after two years: $7,200
Total investment: $2100
Scenario A: Lump-sum purchase on Jan 1, 2018
Amount of bitcoin purchased: 0.1465 BTC
Value of investment after two years: $1,055
Scenario B: Dollar-cost average
Purchase amount and frequency: $20/week for 105 weeks starting on Jan 1, 2018
Amount of bitcoin accumulated: 0.32 BTC
Value of investment after two years: $2,327
Example 1 summary
We can see that dollar-cost averaging results in a modest profit rather than a significant loss.
Example 2: “Catching the bottom”
Here we start with an initial purchase on January 1, 2019, and again consider a two-year time frame.
Bitcoin price at purchase: $3,844
Bitcoin price after two years: $29,374
Total investment: $2100
Scenario A: Lump-sum purchase on Jan 1, 2019
Amount of bitcoin purchased: 0.52 BTC
Value of investment after two years: $15,274
Scenario B: Dollar-cost average
Purchase amount and frequency: $20/week for 105 weeks
Amount of bitcoin accumulated: 0.2584
Value of investment after two years: $7,591
Example 2 summary
We can see that dollar-cost averaging, while resulting in less profit than a lump-sum purchase, nevertheless resulted in significant gains.
Advanced dollar-cost averaging
In the above examples, we relied on "set it and forget it" dollar-cost averaging. With "advanced" dollar-cost averaging, you take on a slightly more active role with the aim of buying more when you think the price is undervalued, and less when you think it’s overvalued. To help inform your decision-making, you can take advantage of ‘technical analysis,’ which is the discipline of identifying trading opportunities based on past market data and statistical trends.
Importantly, since you’re still dollar-cost averaging, you don’t need to be a “pro” trader for this strategy to be effective. That’s because you’re still hedging your risk by making smaller individual bets.
Let’s look at a single basic (but powerful) technical indicator - the 200-day moving average:
In the above chart, the blue line is Bitcoin’s price, while the black line is the average price over the last 200 days. Note that the black line is much smoother (less volatile) than the blue line. We can use the relationship between these two lines to indicate when, on average, it's a good time to buy bitcoin. That's because, historically, Bitcoin - like almost every other traded asset - tends to 'revert to the mean.' In other words, when the actual price deviates significantly from the long-term average, we can expect the actual price to come back to the average fairly soon.
As it relates to our dollar-cost averaging strategy, looking at the above chart, when the blue line (actual price) is close to or below the black line (200-day average), we can take it as a signal to buy more. Conversely, when the actual price rises significantly above the 200-day average, we can take it as a signal to buy less (or potentially even sell some). Employing this strategy will, over time, reduce the number of instances you “overpay” for bitcoin while increasing the number of instances you “buy the dip.” The net result will be that you accumulate more bitcoin for fewer dollars.
The risk associated with "advanced" dollar-cost averaging
Markets have a way of getting under the skin of participants, causing them to make risky bets in order to "beat the market" - and the reality is, over a long enough time horizon, most active traders don't beat the market. For this reason, the more passive "set it and forget it" dollar-cost averaging strategy tends to perform well enough. It provides market participants exposure to the market while minimizing the risk of huge losses.
Will dollar-cost averaging always result in profit?
The short answer is no. If the asset you’re investing in never increases in value, you simply can’t make money on it. Therefore, you should only engage in a dollar-cost averaging strategy if you believe in the long-term fundamentals of an asset.
Dollar-cost averaging reduces your risk while still providing exposure to the upside of an asset. If you believe in the long-term fundaments of an asset but you're not sure where in the market cycle the asset is at the moment, dollar-cost averaging is a relatively safe and low-stress way to enter the market.