The year 2020 set several new records for financial markets as we witnessed the steepest (although not deepest) equities crash ever recorded alongside peak volatility. The months following the market crash in March, 2020 saw an incredible bounce back with the S&P taking as little as five months to reach new highs. In this time, a record number of new entrants to equity markets were recorded, as many took advantage of the excess capital given by stimulus. This mass arrival of individuals, largely millennials and gen-z, benefited from the recovery that followed showing many just how much money can be made in the markets. With so many inexperienced investors heavily involved in the market, risk mitigation in investment decisions is often overlooked. As the digital asset space sees exponential growth and price direction becomes more uncertain, understanding the value of dollar-cost-averaging (DCA) over speculative guessing is of paramount importance.
What is dollar-cost-averaging?
Dollar-cost-averaging is a widely used investment method that aims to secure a lower entry price across an asset by investing a percentage of your allocation consistently over time.
A simple example can be seen below:
Charlie chooses to invest US$120,000 into Bitcoin (BTC) after he hears that some friends have made a significant profit since the March 2020 crash. As he was aware of what happened in the 2017 crash, he is sceptical and allows himself six months to allocate the position. By dollar-cost-averaging into Bitcoin regardless of current affairs or emotion, Charlie profited 72% and secured 0.5178 more Bitcoin than if he had speculated. A very realistic example of how someone might have allocated their US$120,000 investment based on speculation can be seen below.
- He placed US$10,000 in to test the waters at the end of November, 2020.
- By the end of December, he has profited on his investment and decides to add a more significant position of US$30,000.
- After a solid performance at the start of January, he gears up to contribute more capital to the investment. However, half way through the month the asset tumbles, sparking fears for many investors that the bull run is over. While fear is rampant, Tesla has announced that they have placed BTC on their balance sheet. As such, he adds a small increase to his position of US$10,000.
- February sees a similar move and Charlie fears that may have been the last push. As such, he pulls out half of his base invested capital (US$25,000) and leaves the rest, hoping this is not the end of the run.
- BTC spends the month of March 2021 recovering and a new support is found, increasing confidence backed by the S&P conquering new highs and continued institutional adoption of digital assets. Charlie feels he knows the market well by this point. He has learnt about BTC’s halving cycle and sees big names such as Bloomberg calling for 6-figure Bitcoin by the end of 2021. He places US$50,000 in with high conviction.
- Last April saw BTC creep to new highs before tumbling below Charlie’s March buy-in. At the end of April, he saw the opportunity to take advantage of continued upside while lowering his average investment cost. He placed the rest of his allocated investment (US$45,000) into BTC in anticipation of new highs.
While Charlie successfully allocated all of his intended investment and profited +46% at a BTCUSD price of US$60,000, there were a number of errors made due to psychological factors and his inability to time the market. No fault of his own; timing the market is an incredibly difficult thing to do, even for the best active managers in the world.
The following chart gives a great overview of the typical psychological stages and pitfalls of investing. When ‘depression’ hits, it’s normally sell time for most investors. DCA is a way to systemise investment entries and exits in order to improve pricing and avoid psychological investing traps.
That is why dollar-cost-averaging is so valuable, particularly for retail investors that find themselves caught in the cycle above. By consistently investing the same amount in each period regardless of short-term volatility, the risk associated with their long-term investment is reduced. As more enter Bitcoin and the broader crypto market for the first time with the hope to protect their long-term wealth, dollar-cost averaging provides a simplistic and more beneficial method of investment to this volatile asset class.