Stocks and cryptocurrencies can be very volatile and the price of assets can fluctuate wildly.
A common strategy used by investors to protect themselves against volatility is called Dollar-Cost Averaging (DCA). To DCA, an investor will divide the total amount to be invested over a period of time regardless of the market price. This is especially useful if you are uncertain about the timing of your purchase: perhaps you really want this asset but fear it is currently overbought and due for a short-term correction.
By DCAing, you will purchase say 1/10 of your desired amount today, another 1/10 next week, another 1/10 the week after, etc. This way, you can take advantage of dips in price to reduce the cost basis of your purchase. When the price of the asset goes up, your money buys fewer shares per dollar; when the price goes down your shares per dollar ratio goes up.
Investopedia gives a great example of DCA in action:
“For example, assume an investor deposits $1,000 on the first of each month into Mutual Fund XYZ, beginning in January. Like any investment, this fund bounces around in price from month to month.
In January, Mutual Fund XYZ was at $20 per share. By Feb. 1 it was at $16, by March 1 it was $12, by April 1 it was $17, and by May 1 it was $23.
The investor keeps steadily putting $1,000 into the fund on the first of each month while the number of shares that amount of money buys varies. In January, $1,000 bought 50 shares. In February, it bought 62.5 shares, in March it bought 83.3 shares, in April it was 58.2 shares, and in May it was 43.48 shares.
Just five months after beginning to contribute to the fund, the investor owns 298.14 shares of the mutual fund. The investment of $5,000 has turned into $6.857.11. The average price of those shares is $16.77. Based on the current price of the shares, the investment of $5,000 has turned into $6,857.11.
If the investor had spent the entire $5,000 at once at any time during this period, the total profit might be higher or lower. But by staggering the purchases, the risk of the investment has been greatly reduced.
Dollar-cost averaging is a safer strategy to obtain an average price per share that is favorable overall.”
Even the most seasoned investment professionals find it very difficult to consistently predict the bottom of a dip or the top of a high. With DCA, their returns will follow the overall trend of an asset rather than a specific entry price.
Keep in mind that DCA is a long-term strategy that takes advantage of the market’s constant volatility. Bull and bear markets come and go but over time, with proper DCA discipline, “your portfolio will reflect both the premium prices of a bull market and the discounts of a bear market” (Ibid Investopedia).
In sum, DCA is a great strategy to use to hedge your risk against riskier investment plays.
Enjoyed this article? Like and follow me.
Want to continue the discussion? Leave a comment below.
Disclaimer: This is not financial advice. Perform your own research before investing in any asset.