10/1/2008 9:00 AM ET|
Methods for investing in mutual funds
FUNDS 106: Should you decide to invest in a mutual fund, you will have to decide how much to invest and when you will invest it.
It's hard enough to decide whether to invest with an adviser and to commit to a portfolio goal. In addition, you have to decide how much money to put into funds, and when.
If you're fortunate enough to have money to invest, you'll need to choose one of the following approaches:
- Wait to invest your jackpot until your favorite fund cools off or heats up.
- Invest the entire wad immediately.
- Put a little bit to work at a time.
You should be aware that the route you choose can have a profound impact on your return.
Waiting, or market timing
Let's start with the first route, holding off on an investment until you sense the time is right. That can mean when the fund's performance falls, when it rises or when the moon is full on an odd-numbered day of the week in a month beginning with J. Such a strategy is often called market timing.
As you can probably sense, we're not keen on market timing. Evidence suggests that it just doesn't work. Predicting the future has never been easy -- just ask anyone who has had his or her fortune told. Further, studies from Morningstar have shown that investors' timing often leaves something to be desired -- they buy in when a fund is ready to cool off and sell when its performance is ready to pick up.
And even if you make the "right" market call, the mutual fund world usually doesn't reward you in a dramatic enough way to make the risk worth it.
Chalk it up to the cruelty of mathematics, as illustrated in an experiment conducted by Morningstar. We went back 20 years and assumed that in each quarter, an investor chose to own all stocks (represented by the Standard & Poor's 500 Index ($INX)) or all cash (in our experiment, Treasury bills). A market-timer who correctly picked the better performer half the time still ended up way behind the market after two decades. We found that not until the timer's hit rate reached 65% did he beat the S & P 500. In other words, the market-timer had to be right two out of three times to justify the effort.
This is largely because, over time, investing in the stock market has notched higher gains than holding cash. Botching a market-timing decision usually means sacrificing good performance. Worse, missing a period of strong returns means giving up the chance to make even more on those returns, thanks to the effects of compounding. (That is, each year you earn returns on the returns you earned in prior years, as well as on your initial investment.)
Investing all at once, or lump-sum investing
If market timing is a losing strategy, what about the opposite: putting all the money to work at once? Many financial advisers recommend this approach above the others, because the market goes up more often than it goes down.
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