Over the past two weeks in our Bear Market Tactics series, we have explored how to read on-chain data and conduct on-chain financial analysis.
The combination of this type of analysis can help investors understand where the market is and where it may be going.
However, once you have managed to identify promising opportunities to start allocating capital, what is the most efficient way to do it?
This is where dollar-cost averaging can be helpful. This technique works well in bear market conditions, and once these on-chain indicators start signalling to buy, this is probably the most effective method to start allocating your funds.
What Is Dollar-Cost Averaging?
Also known as unit cost averaging, incremental trading, or the cost average effect, the term dollar-coast averaging was first coined by Benjamin Graham in his famous book The Intelligent Investor. According to his definition, dollar-cost averaging “means simply that the practitioner invests in common stocks the same number of dollars each month or each quarter. In this way he buys more shares when the market is low than when it is high, and he is likely to end up with a satisfactory overall price for all his holdings.”
More simply, dollar-cost averaging is a strategy investors can follow by investing smaller amounts into an asset over time instead of all at once. This can have several benefits for a portfolio and is particularly effective during a bear market.
How Does Dollar-Cost Averaging Work?
Many people naturally follow a dollar-cost averaging approach; this is because they usually take a portion of their savings every month and invest it into assets (such as a retirement fund or 401(k)). However, if you have a lump sum you want to invest, this intentional dollar-cost averaging may be a more suitable approach.
When you follow this approach, it may provide an investor with the opportunity to buy assets at a lower price. It is challenging to tell where markets are going in the short term, and therefore by spreading your purchases over an extended time period, you can potentially get a lower average price for the asset you have been purchasing.
When stocks and other assets go down, people become very fearful and start selling, and the opposite holds true as well, as markets rise, people start rushing in and purchasing stocks that may be about to drop in price. Therefore dollar-cost averaging can lead to a more disciplined investing style and help you override emotions you may experience during a bear or bull market.
When taking a dollar-cost averaging approach, there are three decisions that need to be made:
- the total amount you intend to invest
- into how many portions you want to split the total investment
- the frequency of how often you invest the portions
Once you have confirmed the above, no further decisions need to be made, hugely reducing the emotional risk involved when it comes to investing.
The Maths Behind Dollar-Cost Averaging
So how does the maths behind dollar-cost averaging work in practice?
Say you plan on investing $1200 into a fund or asset over one year. If you break it into equal portions, that will mean you are purchasing $100 each month.
Instead of purchasing it once-off at today’s price of $10 a share, what would be the result if you did follow a dollar-cost averaging approach?
If you followed the above example and spread out your purchases, you would have saved yourself 42 cents per share by the end of the year.
If you bought $1,200 worth of your chosen asset at a price of $10 per share in January or December, you would own 120 shares.
If you bought $100 worth of your chosen asset a month for 12 months, your average price per share would be $9.58, and you would own 125.24 shares.
You can see by the above example that dollar-cost averaging can reduce the cost basis of your asset and end up helping you over the long run. However, this approach still comes with its disadvantages.
Drawbacks Of Dollar-Cost Averaging
The two biggest drawbacks that one may experience following this approach are the higher trading fees and the possibility of missing significant upside if you start allocating at the bottom of the market.
Many brokerages and exchanges charge their clients per trade. As you can imagine, the more frequently you trade, the higher your trading fees will be. If you have a broker or exchange that charges low fees, it will not affect you as much, so understanding your trading costs is essential as it may impact the effectiveness of the dollar-cost averaging approach.
The second biggest pitfall is sometimes if the market starts rising quickly, you may lose out on a portion of the gains you would have made if you had just invested a lump sum. However, timing a market bottom is very difficult, with most professional investors not even able to do it; therefore, it still lowers your risk following the dollar-cost averaging approach, albeit at the chance of sacrificing some upside.
Using on-chain analysis can be extremely powerful when you combine it with a dollar-cost averaging approach. While on-chain analysis cannot tell you where an exact bottom is, it can help you understand that you are getting close to a potential market bottom and, therefore, should start allocating capital over the next few weeks/months.
How To Dollar-Cost Average In Crypto
Dollar-cost averaging isn’t that different in crypto to the traditional world. You will have to set up an exchange account, fund it and start allocating capital. Because you can combine other forms of analysis that may give you an edge, you can incorporate these into the three decisions you have to make that we discussed previously. If you think that we are close to a market bottom, you can break your portions unequally and weigh the first few higher.
As an example, if you want to invest $1000 over ten weeks, for the first four weeks, you can invest $150 each week, and for the remaining six, you can invest $67. Feel free to change the amounts and the frequency. However, once you have decided on your approach, you need to stick to it.
Some exchanges, such as Coinbase and Binance, have built-in handy tools that allow you to set how often you would like them to automatically buy on your behalf. This can make it even less emotional as you now don’t even have to think about the process, and it happens in the background.
While dollar-cost averaging does have some drawbacks, it can be an effective way to invest over time, especially in bear markets. Using a combination of on-chain analysis and dollar-coast averaging can provide you as an investor with a highly efficient way to either add to your current positions or purchase crypto for the first time. This approach will reduce the emotion you feel when making investments and therefore reduce the number of potential mistakes you could make.
If you have any questions or have trouble using the network, please feel free to reach out and ask us questions. We always look forward to chatting with our readers. Otherwise, please feel free to share this article if you know anyone who is interested in learning more about dollar-cost averaging.
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This is not financial advice. All opinions expressed here are our own. We encourage investors to do their own research before making any investments.