Dollar-Cost Averaging is an investment strategy that helps traders balance out the risk in their portfolios. Read more to find out what it entails, how to use it, and also how it applies to crypto in today’s market.
It may sound a lot more complicated than it is, but it’s easy to understand Dollar-Cost Averaging if you think of a 401(k) or other type of retirement savings plan. In such a plan, you put a predetermined amount each pay period toward an investment for the many years you are with a company.
So you have a perfect example of Dollar-Cost Averaging, which is an investor’s tool that involves the following features:
- A predetermined amount to be invested is set.
- That amount goes into the investment vehicle (such as the 401(k)) or RRSP (Registered Retirement Savings Plan) at regular intervals.
- This arrangement is set for long term investing.
- It doesn’t matter what the price of the assets is in your 401(k) plan or RRSP (Registered Retirement Savings Plan) from pay period to pay period. The same amount is put towards the investment each time, regardless of that day’s price. Sometimes, you will be able to buy more shares with your $100 contribution. Other times, less.
- You don’t need a lot of money to start investing this way.
The Definition of Dollar-Cost Averaging
Dollar-Cost Averaging is a tool that investors use to build wealth over a long period of time. They invest by using a set amount, with regularly scheduled buys that can stretch out over years. Additionally, it’s a helpful way to keep emotions out of the investment decision process. Something of a ‘set it and forget it’ strategy.
Using this method, investors are able to accumulate a position in the market over time. By leveraging regularity and long term planning, they can hedge against market volatility. While some buys will happen when prices are high, typically more buys happen during the lows.
The key is to benefit from long term growth using incremental buys that tend toward a more valuable market position than with day trading and one-time buys. The cost of the shares investors are buying is sometimes high and sometimes low, but the average-cost presents an emotion-free way of consistently buying in a growing market.
What are the benefits?
Investors that use this strategy are able to enjoy many benefits, including:
- It gives them a way to build their savings.
- They can grow the wealth that they already have.
- This is one way of neutralizing the short term volatility of other investments.
- Regular investment savings is a good habit; it gets you used to putting away small increments that add up over time.
Dollar-Cost Averaging is not a guarantee of better returns or prices. But it does give the investor more opportunities to buy at different prices, without being beholden to FUD and FOMO.
We often tend towards buying on an upswing when prices are generally higher. By automating the process and spreading it out over time, traders may be able to avoid this type of emotional, reactive buying.
How Does it Work?
If you take a look at the chart below, you’ll see an example of someone contributing the same dollar amount every pay period. You can see the fluctuating share prices of the particular investment (i.e. a stock or a fund), as well as the cumulative number of shares bought.
Dollar-cost averaging is not limited to retirement accounts but it is suited to them quite well. But any set investment amount that you can set up to recur regularly over a long period of time would be an example of the dollar-cost averaging method.
Crypto-Cost Averaging
In the current crypto market, there tends to be considerably more volatility than with traditional markets. A case can be made that digital assets are even more suited to dollar-cost averaging than other stocks and funds.
Of course, the more extreme highs and lows also put traders at risk of being influenced by and acting on emotions. All the more reason why a crypto-cost averaging set-up may be a good idea.
We do know that cryptocurrencies are at their nascent stages and long term growth seems imminent with many of them. Because of these reasons, dollar-cost averaging might be an appropriate investment strategy depending on your financial situation.
Drawbacks
Just as with dollar-cost averaging of stocks, automation may put traders at a disadvantage in the crypto market. That’s because they may become complacent and not pay attention to news that could affect their investments. New technological breakthroughs are announced almost daily with hype and trend trading proliferating easily. It’s important to keep your eyes on any markets that affect your portfolio. There could be a big news story that would make your recurring buy a sub-par investment. If you have some or most of your investing set up as automatic, it’s possible you could be missing out on some opportunities.
- This method is obviously not great for big, one-time investments or day trading.
- The fees can vary broadly and add up quickly.
- At this time of writing, there are only a few options for making recurring crypto buys.
All in all, crypto-cost averaging is one way to hedge a volatile, emerging market. You gain exposure that builds over time without the stress of reacting to FUD and FOMO. On top of that, each investor may get some level of protection from the crazy ups and downs of the crypto market.
Where Can You Set Up Crypto-Cost Averaging?
Self Directed 401(k)
If you are in the US, self-employed, and have no full-time employees, you may be able to set up what is called a Self Directed Solo 401(k) or even a Roth Solo 401(k), both of which are retirement plans that carry extensive tax benefits. Unlike the traditional 401(k), investors can open a Solo plan, roll over retirement funds into it and essentially become the trustee with “checkbook control”. This means you determine how the fund is spent, including recurring crypto buys. As of this writing, there’s nothing in the US tax code that says you can’t do this.
Coinbase
For over a year, Coinbase has been one of the only cryptocurrency exchanges to offer recurring buys of crypto like Bitcoin. If you want to learn more about setting that up, here is a tutorial.
There are a number of crypto projects that are coming out with trading features such as recurring payments. So far, Coinbase seems to be the only one that is actively doing this.
Another option for the future is to use trading bots, which automate transactions based on specified indicators. None at the moment are advertising for crypto-cost averaging but it’s likely that this feature will be added to many companies and exchanges as scalability improves.
Summary
Dollar-cost averaging can lower the emotional roller coaster of traditional investments, and in particular, crypto trading. Automating decisions and diffusing emotional swings by investing regularly over time can help investors gradually gain a market position. But it’s to their benefit to continue to monitor their investment choices as well and not become complacent. Then they are able to reassess and reallocate to their benefit when the market sees a shift.
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