Dollar Cost Averaging Explained
Dollar cost averaging Bitcoin is the practice of buying Bitcoin a little bit at a time over a long time period. Because you are buying Bitcoin at different times, you are likely also buying it at different prices. This is where the ‘average’ comes into play. The ‘average’ price you are buying Bitcoin more accurately reflects Bitcoin’s average price over the life of the asset.
Why Should You Dollar Cost Average?
The reason you would want to dollar cost average you Bitcoin is to decrease your risk from Bitcoin’s volatility. If you only buy Bitcoin one time, you are engaging in a kind of gambling that right now the price is low and won’t go lower in the future.
If you are wrong and the volatility in the price moves it down, you will lose money. However, if you only buy a little bit every month, then you are entering Bitcoin at many different prices, so the volatility will not affect your profitability as much.
Example of Dollar Cost Averaging
To understand dollar cost averaging in practice, let’s look at two scenarios.
Scenario 1
You want to buy Bitcoin and you have a total of $10,000 to invest for the whole year.
Month 1
The current price of Bitcoin is $10,000.
You decide to invest all the money right now, and acquire 1 Bitcoin.
Month 2
The price of Bitcoin goes down to $9,000. You have lost $1000.
Month 3
Bitcoin goes to $11,000. You have gained a total of $1000.
Month 4
Bitcoin goes to $8,000. You have lost a total of $2000.
The entire time, your average Bitcoin acquisition price is $10,000 because $10,000 divided by 1 (purchase) is $10,000.
Scenario 2
You want to buy Bitcoin and you have a total of $10,000 to invest for the whole year.
Month 1
The current price of Bitcoin is $10,000.
You decide to invest $1000 a month, regardless of the price of Bitcoin. So you invest $1,000 and acquire .1 Bitcoin.
Month 2
The price of Bitcoin goes down to $9,000.
Your dollar cost averaged Bitcoin price at this point is $9,500.
Month 3
Bitcoin goes to $11,000. You invest $1,000 and acquire .091 Bitcoin.
Your dollar cost averaged Bitcoin price at this point is $10,000.
Month 4
The next month, Bitcoin goes to $8,000. You invest $1,000 and acquire .125 Bitcoin.
Your dollar cost averaged Bitcoin price at this point is $9,500.
Takeaways
The lesson to take away from these scenarios is not that you will always make more profit if you dollar cost average your Bitcoin purchases. Anyone can invent fictional scenarios where dollar cost averaging looks good or bad.
The point is that buying Bitcoin (or any asset for that matter) at a bunch of different prices prevents an investor from having to experience the emotional swings that occur from short term volatility in the price.
You’ll notice that in the second scenario, the investor is not experiencing 10% gains one month, then 20% losses the next.
As a trader who dollar cost averages, you accept that you will be buying Bitcoin at the highs, but those ‘bad’ purchases will be offset because you will also make sure you are buying at the lows as well. You, therefore, do not need to take the gamble that you will be right about what the price of Bitcoin will be. Instead, you can just set your investments and forget them.
If you want to see more examples of dollar cost averaging at work, you can run through these simulations.
Advantages of Dollar Cost Averaging
Dollar cost averaging can be hugely beneficial for a number of reasons.
First, it helps stop you from panic buying major price movements in Bitcoin. For instance, if the price runs up really quickly, it is often tempting to “panic buy” and actually buy a local high, killing your profitbility. Likewise, it can be tempting to “panic sell” a price dip that recovers as soon as you sell.
Second, removing all the guesswork from trading Bitcoin can also be a huge mental health benefit, since you no longer need to worry about buying low and selling high.
Finally, dollar cost averaging tends to mitigate alot of the short term effects of price volatility.
Basically, dollar cost averaging is for traders who are mature enough to know they don’t know the future, and don’t want to rely on their own intuitions when making trades.
Disadvantages of Dollar Cost Averaging
There are a few disadvantages to dollar cost averaging.
First, because you are making many trades (once a week, month, etc), you may experience more fees if the fees are charged per trade. This can affect the profitability of your trades.
Second, you may miss out on profits in the case you get lucky and buy in bulk at a low price. That being said, the whole point of dollar cost averaging is to remove luck as much as possible from our trading strategy. After all, luck is not a strategy - its just gambling. But we need to take the bad with the good, and for some of us, dollar cost averaging may mean we’ll miss out on profits when it turns out we were right about that very low price we were so sure of.
Does Dollar Cost Averaging Really Work?
Dollar cost averaging is designed to eliminate short term volatility in portfolio value. Dollar cost averaging is VERY effective at doing this.
Best Ways to Start Dollar Cost Averaging Bitcoin?
The absolute best way to start dollar cost averaging your Bitcoin purchases is to funnel your 401k money from your job into a Bitcoin IRA. This way, every month you are setting aside savings to accumulate your Bitcoin ina tax advantaged account.
If you don’t have a 401k, or you want to hold the Bitcoin yourself, then the best to acquire Bitcoin using dollar cost averaging is to us a company like Swan Bitcoin that is designed to buy Bitcoin for you at regular intervals.
You can also use the Cash app to buy Bitcoin in a fixed dollar amount and at specific intervals.
You can now do automatic recurring purchases of #bitcoin in @CashApp. Daily, weekly, or every 2 weeks. And change the display to sats. #stackingsats pic.twitter.com/kOlxQtkuwd
— jack (@jack) May 18, 2020
FAQ
How do you calculate dollar cost averaging?
To find your dollar cost average of your Bitcoin purchases, you do:
So, taking from the example above, if you purchased:
- $1000 for .1 BTC
- $1000 for .091 BTC
- $1000 for .125 BTC
Then you Spent $3000 for .316 BTC
so…
would equal a dollar cost averaged Bitcoin price of $9,493.67.
How does dollar cost averaging affect taxes?
One unfortunate side effect of dollar cost averaging is it makes it difficult to calculate your cost-basis which is the method used to calculate capital gains.
Cacluating cost basis is outside the scope of this article, but its worth being aware that you will need to decide which method for calculating cost basis is best for you. It’s also worth being aware that dollar cost averaging does make calculating cost basis more difficult, but there is some great software out there to make it easier.
