By Chris O’Neal, CPA, MBA
The cryptocurrency ecosystem has enjoyed major growth over the past few years, prompting many newcomers to invest in the space. However, the growth of cryptocurrencies like Bitcoin and Ethereum is underpinned by price volatility. While the price of a given cryptocurrency might skyrocket, sharp drops in price are also possible. The cryptocurrency world is famous for short-term crashes in a single day or week. This could result in large losses for an investor if they have made an ill-timed large purchase of a cryptocurrency immediately before it experiences a downturn.
Dollar-cost averaging (DCA) is a basic investment strategy designed to mitigate the risk of price volatility that investors face in a market. It is especially useful for situations where the investor expects volatility in the immediate future or due to the nature of the market. Because cryptocurrencies like Bitcoin, Ethereum and Shiba-Inu are volatile, dollar-cost averaging can be a particularly useful strategy for minimizing risk.
It is very simple to apply dollar-cost averaging to cryptocurrency investment. Instead of making a lump-sum investment – a strategy best used when an investor wants to maximize their exposure to potential price appreciation – dollar-cost averaging breaks up the investment into multiple fixed-size sums, which are invested at fixed intervals over a period of time.
In a hypothetical scenario, an individual might have $1,200 they wish to invest into Bitcoin. However, they also notice that the price is particularly volatile at the time they want to invest. They have fears that if they purchase the Bitcoin the price may suddenly drop – but they don’t want to try to ‘time the market’. To reduce their potential downside and also take the emotion out of investing, they choose to dollar-cost average.
Dollar-cost averaging can take place over any timeframe but is typically done over a period of weeks or months. The investor decides to spread the $1,200 investment over twelve months. They commit to purchasing $100 Bitcoin on the first of every month – regardless of the current price – so that at the end of the twelve-month period they will have invested the full $1,200. At the end of the third month, the investor’s fears are materialized when the price of Bitcoin drops dramatically. However, the investor has only invested $300 so far, or one-quarter of their total investment. Because they have used a dollar-cost averaging strategy, the investor’s losses are much smaller than they would have been if they had invested the $1,200 in a lump-sum.
The investor continues to invest $100 each month after the sudden crash in Bitcoin’s price. Now they can take advantage of the lower price, receiving more Bitcoin for each $100 purchase they make. As the twelve-month timeframe draws to a close, the price of Bitcoin has largely recovered, and the investor has been able to accumulate more Bitcoin than they would have if they had made a lump-sum investment of $1,200 before the crash.
This hypothetical scenario is an example of when dollar-cost averaging is very practical. The investor was able to capitalize on the volatility of Bitcoin, without having to ‘time the market’. Even when an investor does not wish to spread out a lump-sum investment, dollar-cost averaging can still be useful. If an investor has a tight budget limiting how much they can invest, they may decide to stick to a dollar-cost averaging strategy – investing $25 every week or month in Ethereum for example, regardless of the price. This helps to reduce emotional investing while allowing an investor to continually add Ethereum to their portfolio.
We tell our Nealson Group clients there is no investment strategy without risk, and dollar-cost averaging is no exception. Dollar-cost averaging cannot protect an investor against long-term market downtrends where asset prices continually fall. Dollar-cost averaging may also limit an investor’s gains even when the asset appreciates. Because investors limit their exposure in the short term in comparison to lump-sum investing, investors may miss out on sudden appreciations in price by dollar-cost averaging. This is a very important consideration when using dollar-cost averaging for cryptocurrency investment. In the hypothetical scenario earlier, if Bitcoin had surged in price during the investor’s dollar-cost averaging strategy, they would have missed out on gains they would have made if they had invested their $1,200 upfront. If an investor expects the price of an asset to appreciate, they should consider making a lump-sum investment if possible.
Dollar-cost averaging is a useful tool in an investor’s toolbox for particular situations. It should be used when the investor expects the price of an asset (such as a cryptocurrency) to drop in the short-term, or when they have a limited investment budget. Dollar-cost averaging can greatly reduce the risk of investing in volatile markets, including the cryptocurrency market.
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