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What Is Dollar-Cost Averaging and Is It a Good Strategy During Down Markets?

Post on July 14, 2022 in Blog

During economic downturns, people often ask if they should pause their 401(k) or IRA investments. The thinking is that it would be better to cash out on their investments and then reinvest when markets recover.

This, however, can be a huge mistake, as investing during a down market could benefit you the most. To understand why this is, we’re looking at the importance of dollar-cost averaging during market downturns.

Before we get started, it’s important to remember that there are no guarantees. Investing can be risky, making it essential you research potential investments and do your due diligence. When in doubt, consult a trusted financial advisor.

Now, with that out of the way, what is dollar-cost averaging?

Dollar-Cost Averaging Explained

If you contribute to your 401(k) every paycheck, you’re already dollar-cost averaging. Essentially, dollar-cost averaging just means investing in (usually small) increments at set intervals. Doing so lets you buy assets like stocks and crypto at a variety of different prices, rather than making a single, larger investment at one cost basis.

This can be a powerful investment strategy, because investing during a bad week for the markets effectively means you get more shares for your investment dollars.

IRAs, however, with their lower yearly contribution limits of $6,000 (or $7,000 if you’re over the age of 50), aren’t always contributed to with the same consistency as 401(k) accounts. Instead, some opt to make one large contribution or just a handful of contributions across the year. This could be a good strategy if you have the funds to do so-research by Northwestern Mutual Wealth Management suggests that versus dollar-cost averaging, lump-sum investing yields better returns in the stock market over the long run.

Most of us don’t have piles of investment capital ready to deploy at a moment’s notice, though, making dollar-cost averaging a more manageable, budget-friendly investment strategy. Additionally, research by Vanguard found that dollar-cost averaging resulted in fewer losses during down markets.

Dollar-Cost Averaging vs. Buying the Dip? Why Timing the Market Is Hard

If investing when a stock or cryptocurrency is at its lowest price will yield the greatest returns (assuming an asset’s value recovers; remember, there are no guarantees), why not just wait for the market to go down and invest all you can then? In short: Timing the market is exceedingly difficult.

Consider that some of the world’s most famous investors (like Warren Buffett) advise that it’s impossible to time the market. And not only that, Alto’s own research found that 60% of millennial investors believe you have to be a professional investor to get ahead in the stock market.

Dollar-cost averaging could be the next best thing. When the price of an asset is going up, in the long run, this week could offer a better value for you than next week. Similarly, when the market is going down, $100 this week might not get you as much of an asset as $100 next week. But it will certainly get you more than the weeks prior!

As a result, dollar-cost averaging allows you to reduce your exposure to any one price. For this reason, dollar-cost averaging can be an especially effective investing strategy with risk assets, like stocks and crypto. And by investing in crypto using an IRA, you can avoid the complicated and often messy tax filing process while reaping the long-term benefits of potentially tax-free or tax-deferred gains.

Traditional Vs. Roth IRAWhat’s the Difference Between Tax-Free and Tax-Deferred Investing?
Read our blog comparing traditional vs. Roth IRAs to decide which tax-advantaged investment strategy is right for you.

Now, let’s look at some dollar-cost averaging approaches you might consider.

How to Dollar-Cost Average

Generally speaking, the easiest dollar-cost averaging approach is going to be to contribute a fixed amount per paycheck—whether that’s weekly, biweekly, or monthly. (Note that in the case of a monthly paycheck, you might set money aside each pay period but opt to make multiple contributions during the month.)

Of course, some people would prefer to dollar cost average at a much greater frequency—like daily.

Given how much crypto markets fluctuate, this could be a particularly savvy strategy, allowing you to truly buy the dip without committing too much of your investment funds at once.

Be aware though that in the case of such frequent contributions, it’s important to consider how a custodian or exchange makes their money. With just trade fees, your fees will average out regardless of intervals. However, if a custodian or exchange charges a minimum investment fee on small contributions, you might want to put some thought into how much your strategy will cost you.

There are other considerations, as well.

Dollar-Cost Averaging and Taxes

When developing your dollar-cost averaging strategy, it’s important to keep in mind the type of investment account you plan to use. With a qualified (meaning retirement) account, you get special tax advantages that do not apply to non-qualified/brokerage accounts. Namely, when investing in a 401(k) or IRA, you won’t be subject to capital gains taxes or complicated yearly reporting requirements. That is assuming you wait until you’re eligible to take distributions.

So while you can make daily contributions to an account you hold with an exchange, when you go to sell, you’ll have to report each and every purchase and sale.

Avoid Taxes on Crypto

Crypto Tax Requirements Have You Confused?
For more on the complexities of crypto taxes, read our blog post, How to Avoid Paying Taxes on Crypto.

Determining an Investment Budget

Whatever investment amount or frequency you decide to go with, it’s important to set a budget up front. Particularly in the case of daily contributions, it can be very easy to contribute too much of your funds. Remember that in most cases, you cannot pull money out of retirement accounts easily or without tax penalties. So you really want to be careful to avoid draining your bank account for what seems like a good opportunity.

One strategy might be to make a single contribution per paycheck to your account—such as a crypto IRA offered by Alto—and then to disperse those funds across multiple days or weeks. That way you avoid investing more than intended (or could afford).

Dollar-Cost Averaging Frequency

Time of day is also a consideration. When it comes to dollar-cost averaging, some people are highly regimented, opting to always contribute at the exact same time of day at their chosen interval. Others elect to do it when they can within a certain period of time (for example, once per paycheck).

Ultimately, it’s up to you when and how often you elect to make contributions and investments. What matters is that you’re investing for your future.

Dollar-Cost Averaging and Portfolio Diversification

As one final consideration, you should avoid putting all of your eggs in one basket. While your confidence in a certain investment may be warranted, it’s likely you’ll come out better in the long run if you diversify your portfolio to include not just multiple assets but multiple asset classes.

One possible strategy you might consider is to allocate your 401(k) to more “traditional” (or public market) investments, like stocks, bonds, ETFs, and mutual funds. Then to harness your IRA for diversifying your portfolio into other asset classes.

Alto was created for just this reason, enabling you to not only invest in cryptocurrencies, but other alternative investment classes, including art, real estate, private equity, venture capital, and more.

If that sounds unconventional, it’s worth noting that large investment institutions, university endowments, and the ultra wealthy have been investing in alternative assets with great success for decades. It’s just that until recently, a bevy of government restrictions and other barriers to entry prevented everyday investors from accessing those same opportunities.

Additionally, because many of these investment opportunities aren’t available through legacy retirement accounts, they’ve been out of reach for the many Americans whose largest source of investable assets are tied up in retirement accounts.

Dollar-Cost Average Crypto with the Tax Advantages of an IRA

Hopefully, this post helps you to better understand what dollar-cost averaging is and how you can use this powerful, yet simple strategy when investing in cryptocurrencies.

Considering the tax advantages of traditional and Roth IRAs, a crypto IRA could be the smartest way to dollar-cost average crypto. Alto CryptoIRA® gives you access to up to 200+ coins and tokens through Coinbase integration—with no account or monthly setup fees, so you only pay a 1% transaction fee when you make a trade.

Open an Alto CryptoIRA today.