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What is dollar cost averaging?

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PDAX

July 14, 2022

6 min read

IntermediateTrading

TL;DR

Dollar cost averaging involves buying an asset with a portion of your total planned investments, spread out over a specified time period, with recurring “buys” that can be done daily, weekly, or even monthly. This strategy provides a stress-free way to invest and helps reduce the risk of incurring large losses compared to a lump-sum investment.

What is dollar cost averaging?

Whether it’s crypto or stocks, getting into investing can be quite overwhelming for a beginner. Given the hundreds of strategies one can choose from, how to best deploy your hard-earned money and maximize profits can be a head-scratcher. But those who prefer a simple and convenient overall  investing strategy often turn to dollar cost averaging–or “peso cost averaging” in our case. 

In dollar cost averaging, the main approach is to buy an asset using a portion of your total planned investments spread over a specified time period. These “buys” are usually done on a routine timeline–either daily, weekly, or even monthly, depending on one’s convenience. Dollar cost averaging is different from a lump-sum investment wherein you buy an asset using the total amount you planned to invest, all at one time. 

The advantages of dollar cost averaging

The main advantage of dollar cost averaging is that it reduces the complexity and stress of constantly having to keep track of the prices and current news events day in and day out. Instead of timing the market to “buy the dip”, you can just stick to your planned schedule regardless of the current market price. 

Sticking to daily, weekly, or monthly recurring buys means removing the emotional stress from managing your position. By maintaining a strict schedule, you effectively eliminate the habit of buying into the hype, otherwise known as “fear of missing out” or FOMO. 

Dollar cost averaging also reduces the risk of bad timing and putting a greater portion of your capital at risk. If others say that you should diversify your assets to avoid “putting all your eggs in one basket”, then dollar cost averaging is equivalent to “not putting all your eggs in one basket–all at one time”. 

Why is dollar cost averaging suited for a bear market?

Bear markets are periods wherein asset prices are falling for a prolonged period of time. Investors and traders alike often take losses during this period attempting to time the bottom in the hopes of buying an asset at its lowest price. However, predicting the bottom is often difficult and involves a lot of pain from catching a “falling knife”--which is buying an asset thinking its price has bottomed only for things to turn out otherwise. 

This is where a strategy like a dollar cost averaging can be useful. Implementing dollar cost averaging during a bear market will bring the average price of your investment much lower relative to its price during a bull market. And in case of a prolonged downturn, losses will be spread out over a larger area, which will translate into relatively more gains when circumstances eventually improve, as compared to just breaking even when one buys in at all once too early. 

Dollar cost averaging vs lump-sum investing during a bear market

To give an example of how dollar cost averaging can help mitigate losses, let’s give a hypothetical bear market situation:

Lump-sum investment sample computation

Let’s say you have PHP10,000 that you would like to invest in Bitcoin (BTC) with Bitcoin’s price trading at USD 50,000. You started hoping for BTC's price to regain its all-time high, but unfortunately, the crypto market experienced an unexpected downtrend, causing prices to drop to USD 40,000 instead after four weeks. This means that you would be losing 20% or PHP 2,000 worth of your total capital allocated towards BTC, leaving you only with PHP 8,000.

Lump sum investment sample computation

Lump-sum investments are only ideal when you are buying close to the bottom, but which is never easy to determine. Predicting when prices bottom during a market downturn requires you to pay close attention to global market updates and to exert a lot of effort in conducting technical analysis on day-to-day price movements. 

Now let’s compare to how you would have fared if you had used dollar-cost averaging instead. 

Dollar cost averaging sample computation

Using the same starting conditions given above, you start out with PHP 10,000 to invest, but this time spreading it out over the next four weeks, buying PHP 2,500 worth of BTC each week. 

You stick to your weekly scheduled buys, but this time instead of losing 20% of your total investment, you end up in a significantly better position at only a ~9% loss. The average cost of your weekly Bitcoin buys would be $36,900 by the end of the fourth week, leaving you with PHP 9,075.

Dollar cost averaging sample computation

As shown by this example, dollar cost averaging allows you to spread your risk and to mitigate losses compared to investing a lump-sum amount at one go during a bear market.However, though many attest to DCA as the soundest strategy for investing, it doesn’t mean that it is always foolproof. A disadvantage of dollar cost averaging is that you could be buying routinely during an uptrending market. 

There is also still a probability that your total investment could end up higher than your initial buys, increasing your risk in the event of a market downturn. And though this doesn’t always translate into a loss, your potential profits will also be reduced since you will be using a smaller portion of the total amount of your investment allocation.

It’s all about weighing the advantages and disadvantages against the current situation of the market. But all in all, dollar cost averaging always offers a less stressful alternative to lump-sum investment and is the most convenient way for most people who may be too busy or occupied to give too much time and effort in monitoring their investments. 

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DISCLAIMER: The statements in this article do not constitute financial advice. PDAX does not guarantee the technical and financial integrity of the digital asset and its ecosystem. Any and all trading involving the digital asset is subject to the user’s risk and discretion and must be done after adequate and in-depth research and analysis.

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