Cryptonomics: Dollar-Cost Averaging (DCA) in a Nutshell

Dollar-Cost Averaging is an investor-friendly strategy that allows users to gain exposure to the market systematically. This strategy typically produces better results than that of a beginner trader but to each their own.

By
Utulu Hope
on
March 10, 2021
Category:
Cryptonomics

Introduction

Experts say, "It is almost impossible to correctly time the market." Without a doubt, to trade in today's market, one has to be very active, monitor signals, checking price statistics, hovering on charts, and other tedious activities. Even with all these practices to profit from trading, it typically does not turn out as expected. The implication is that improving the chances of entering/exiting trades at the right time would require some strategy rather than just buying the dip and selling at a high rate.

Now, you may be asking what ways can make it easier for one to improve one's profitability besides being an active trader. While trading has become quite popular in the 21st century, many people trade without any form of experience. According to a Forex survey, 72% of traders in the Forex market lack experience. However, even with experience, active trading is still time-consuming, but the good news is that many investment strategies require less effort and consume less time. As an investor, you may be looking for this type of investment strategy. There are quite a number of them, and in this article, we will explain one of the less time-consuming investment alternatives to trading: the Dollar-Cost Averaging.

What is the Dollar-Cost Averaging?

One way of investing with purpose is using the Dollar-Cost Averaging (DCA) technique. The Dollar-Cost averaging strategy is a long-term investment plan which involves staking a fixed amount of money on a particular stock at given time intervals. This is just an investment scheme people use in getting a result similar to trading, if not better than trading.

By buying a stock at regular intervals, the effect of volatility is reduced. This method requires that an individual split a certain amount of money into an asset incrementally. Purchases are made at regular time intervals. In this way, a change in the asset's price over time will not affect the entire purchase.

This means that an investor does not have to put effort into monitoring the asset's price to make purchases. Dollar-Cost Averaging is a fixed plan that occurs periodically. To use this plan effectively, one has to understand how the Dollar-Cost Averaging works.

How Does Dollar-Cost Averaging Work?

The DCA strategy is very easy. All you need to do is to invest a specific amount of money on a particular asset or stock at regular intervals such as monthly, weekly, or yearly. In doing this, you have to ignore all fluctuations of the asset's price. Yes, the price may undergo volatility, but it is vital to stick to your investment thesis until adequately invalidated. To make this strategy less of a bother, you can do it automatically by using the asset's dividend as a form of investment. The bottom line is, maintain discipline and do not change your investment plan. The price has to be fixed at the point of purchase.

DCA is dependent on the price of an asset at a given time. This entails that if an asset's value at a particular period is high, your investment will buy fewer units. Similarly, if the value of an asset is low, your investment will buy more units.

Illustration of Dollar-Cost Averaging

With all the explanations, if there is no illustration, it may be difficult to understand. Let us use a representative to paint a clearer picture to understand how the DCA strategy works.

Take, for instance, an investor who wants to invest in an asset over nine months, say from January to September. Now, let's call the asset ABC. Suppose the investor intends to put $90,000 into the asset, which is at a monthly rate of $1000; we should expect the asset ABC to fluctuate as usual according to market standards.

Now let's make this illustration more interesting. Let us assume that asset ABC is a cryptocurrency with a tendency to rise and fall. Just like every other cryptocurrency, ABC trades at different levels each month. In January, ABC cryptocurrency traded at $200 per unit, in February at $230, traded about $250 in March, and maintained this unstable state till September. However, let us look at the first three months of investment, overlooking the other six months. Now a timely reminder — his monthly rate is $1000.

If he continues to stake at a regular monthly rate of $1000, he would have gotten 5ABCs in January, 4.34ABCs in February, and 4ABCs in March. By the end of the third month, he would have gotten 13.434ABCs. The investor, in the space of three months, invested $3000 into the ABC cryptocurrency. We then calculate the investor's 3-month returns. To find this, we multiply the current price of ABC as of March by the amount of ABCs he has allocated. Multiplying $250 by 13.434, the investor made $3358.5 from investing $3000 in three months. This means that the investor made an additional profit of $358.5.

Now imagine if he/she had placed all the $3000 invested in the first month, waiting for it to appreciate. The profit may be higher, but the urge to remove his investment may arise because of the cryptocurrency market risks. But with DCA Averaging, the risks have been lowered. Hence, the DCA strategy is a safe way towards attaining a favorable result in the long run.

Benefits of Dollar-Cost Averaging

From the illustration above, it is clear why you should adopt the DCA strategy. It will reduce the risk of purchasing an asset when not needed. When an investor is interested in buying an asset, timing is an important aspect or skill. And, there is no doubt that it requires a lot of time, effort, and instinct. Sometimes, an investor may monitor the chart well, but his intuition and timing may prove futile. This leads to buying an asset at the wrong time.

However, with the DCA strategy, you don't have to worry about trading at the wrong time because of the reduced risks. Dividing your investments into equal parts is a better and more secure way than investing all your money in a particular asset.  It is very easy to buy an asset at the wrong time. The Dollar-Cost Averaging strategy will help improve your ability to trade effectively without having to waste your time monitoring data and price movements.

This strategy is an automatic decision-maker. However, it is not a sure-bet towards making a profit. It won't erase the risks of investment but is a good way of getting a good entry. The Dollar-Cost Averaging strategy is a suitable mode of access for beginners. However, a decent market timing skill will still come into play when it is time to exit the investment plan.

Having said this, there may be problems with exiting. Of course, you need to set a profit target before adopting the DCA strategy. If the market turns sour, an exit strategy should be adopted. A good exit uses the same DCA strategy to sell your asset once you are approaching the target. Divide all your total investments into equal parts and sell them at regular intervals. By doing this, the risk of exiting at the wrong time is reduced. This exit method is still very much dependent on your market timing skills.

Problems of Dollar-Cost Averaging

Just as "there is no perfect thing in life," the Dollar-Cost Averaging strategy is imperfect. It may be an excellent way to reduce investment risks, but it is most profitable when the market is bullish. Even with this, experts think that the DCA strategy is more limiting than being a game-changer. According to them, the system will eventually make investors gain little when the market is bullish.

This assessment is acceptable because when there is a bullish trend in the market, those who invest a large sum of money will make more profit, unlike those that adopt the Dollar-Cost Averaging strategy. Not all investors have high purchasing power, so the DCA strategy is still an acceptable form of investment in the long run.

Final Thoughts

The Dollar-Cost averaging method is a secure way of making a profit, though it requires patience and discipline. It involves dividing investment capital into several parts and investing at specific time intervals. This strategy promises to reduce the risks of trading and the time an investor takes to monitor a potential profit-making investment.

Although many believe that it may be a suitable strategy, critics point out that DCA returns meager profits on average. Some argue that when there is a bullish market, it is better to make less profit than increase your investment risks. In short, DCA is an investor-friendly strategy that allows users to gain exposure to the market systematically. This strategy typically produces better results than that of a beginner trader but to each their own.

Tags:
No items found.
Utulu Hope

UC Hope is a passionate fan of crypto who could weave the latest event into sparks of inspiration and information. He leaves no stone unturned to get to the core of a story. Aside from writing, he spends his hours poring over algorithms and protocols, preparing for a future career as a computer programmer.