The concept known as dollar-cost averaging, or DCA, has long been used to reduce the volatility of stock and bond market portfolios and minimize the risk inherent in these investments. Dollar-cost averaging takes many forms, including making periodic investments in a diversified mutual fund, reinvesting dividends to purchase more shares and buying into a workplace retirement plan like a 401(k) or 403(b).
The idea behind dollar-cost averaging is easy to understand, and it is designed to put the old bromide “buy low, sell high” into action. With dollar-cost averaging, the investor purchases the same amount of their chosen investment, i.e., individual stock, mutual fund, bond portfolio, etc. month after month and year after year. Investing the same amount on a periodic basis means the investor purchases fewer shares when the investment is riding high and more when its price is depressed. Over time, this helps to even out the swings in the market, reducing volatility and tempering risk.
Most importantly, and the key to remember is that DCA’ing averages out your buy-in point over the lifetime of buying an asset. But why might you want to do this? Timing the market with 100% accuracy all the time is impossible. This means you may buy what you think is the bottom, but the price of the asset keeps depreciating, or you accidentally buy the top. In both scenarios, averaging in would reduce your losses, and when the market went bullish again, maximize your returns.
Dollar-Cost Averaging Into the Cryptocurrency Market
If there was ever a case for dollar-cost averaging, it is in the cryptocurrency market. Cryptocurrencies like Bitcoin, Ethereum and Litecoin, can fluctuate 10%, 20% even 30% or more in the space of a single day, week or month.
That extreme volatility makes dollar-cost averaging a very valuable concept for any cryptocurrency investor to understand. In fact, dollar cost averaging into the crypto market could be far more important than in traditional stock markets, due to the very nature of their wild price swings.
It is easy to dollar cost average into your favorite cryptocurrency, and you can do it on any exchange. If you want to dollar cost average into this potentially lucrative but highly volatile marketplace, there are a few things you will need to keep in mind.
Link Your Bank Account
The first step in dollar-cost averaging is to set up your funding source. That means linking a bank account, credit card, or another payment system on the cryptocurrency exchange of your choice.
Depending on where you live, it can take anywhere from a few hours to a few weeks for your bank account to be fully linked, and until that happens, you will not be able to make any purchases. The exchange will verify your bank account by making a few small deposits, and you will need to sign in to enter those amounts.
Once your bank account or other funding source has been linked, you can set up your recurring purchases. Depending on the exchange, you can make purchases every day, every week, every month or every year. You can also set the day of the month on which to make your purchases, and that can make it easier to track your transactions and manage your bank account.
There is one important thing to understand when dollar-cost averaging into the cryptocurrency market, and that is the price you will receive. Since the price of Bitcoin and other cryptocurrencies is so volatile, the day you buy can make an enormous difference in how much you pay.
Some cryptocurrency exchanges lock in the price on the date you select, even if the funds are not immediately transferred. Other exchanges do not lock in the price, and that means the price you pay could be different from the price on your chosen purchase date. That is an important distinction since it can take a few days for the funds to move from your bank account to the exchange.
Contact Your Bank
One final note about dollar-cost averaging into the cryptocurrency market – it is a good idea to contact your bank before you make your first purchase. Giving the bank a heads up can help you avoid any unnecessary delays since these purchases can sometimes trigger fraud alerts.
Once you have notified your bank that you are planning to buy Bitcoin or another cryptocurrency, the DCA process should be pretty straightforward. You will want to keep track of the purchases you make, along with the prices you paid and any commissions that were added. This will make tax planning, discussed below, and tracking your profits, a lot easier.
Here’s a section everybody hates to read about – taxes. But nevertheless, it’s one of the most important parts of transacting in crypto and investors should be preparing for their tax duties before its due, rather than scrambling to meet tax requirements afterward. Many traders make the mistake of not calculating their tax burden and getting caught out once they decide to take profits. While taxes shouldn’t be any harder to calculate when you’ve used a dollar-cost averaging strategy, there are still a few considerations to keep in mind.
Most importantly, when averaging your buys, you’re going to have a lot more transactions that if you’ve just made one lump-sum purchase. This means that for every transaction, you’ll have to work out a cost basis for the spot price you bought your asset at. For this reason, you’ll need to keep detailed records of all your original cryptocurrency purchases, transfers to exchanges, trades, and when you’re ready to cash out – your profits.
In theory, all of this information should be readily available on your exchange account history. In practice, most traders use a multitude of exchanges, making this harder to track. Additionally, exchanges have been known to shut down due to insolvency or hacks – losing all records of your trades. To protect against this, you should keep your own records of buys, including the price the asset was when you bought it.
Can Dollar Cost Averaging Work for You?
If you are ready to enter the cryptocurrency markets, but you feel overwhelmed at the thought of timing the market for the perfect entry, then dollar-cost averaging could work for you. But always remember these golden rules.
Firstly, set aside the capital you want to invest before you begin to make regular investments into the crypto markets. This way, you are less likely to get carried away and invest outside of your financial comfort zone.
Secondly, don’t get carried away. If you’ve promised to yourself that you are going to invest $1,000 dollars into Bitcoin, and you will buy $100 every Friday for the following ten weeks, don’t be drawn in by price swings. For example, you may see the market moving up and be tempted to invest the rest of your funds right away. This will completely skew your average buy-in, negating the benefits of this strategy.
Lastly, pick an exit strategy wisely. Just as you have meticulously dollar cost averaged into the market, decide on what time horizon you want to invest for and when the time comes to take profits, be disciplined with yourself and trade according to your plan.
Follow these steps, and you’ll be entering into the crypto markets with a solid position in no time!