Funds 106: Methods for investing in mutual funds

By Morningstar.com

It's hard enough to decide whether or not to invest with an advisor and to commit to a mutual fund style or portfolio goal. In addition, you have to decide how much you want to invest in a fund, and when.

If you're fortunate enough to have money to invest, you'll need to choose one of the following approaches:

1. Wait to invest your jackpot until your favorite fund cools off or heats up.

2. Invest the entire wad immediately.

3. 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.

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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 S&P 500) or all cash (in our experiment, Treasury bills). A market-timer who 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.

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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 still, 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 advisors recommend this approach above the others, because the market goes up more often than it goes down.

Here's an example. Say you decide to invest $10,000 all at once in one fund while your friend, who also happens to have $10,000 to invest, instead places $2,000 per month in the same fund over the next five months. The fund consistently rises in value during that time. The chart below illustrates what would happen to the two investments.

Fund value increases

Month	Your investment	Your cousin's investment
1	5,556 shares at $1.80 each	1,111 shares at $1.80 each
2	*	1,099 shares at $1.82 each
3	*	1,081 shares at $1.85 each
4	*	1,070 shares at $1.87 each
5	*	1,053 shares at $1.90 each
Total shares	5,556	5,414
Ending value	$10,556	$10,287
*Not available

You would end up ahead, because you own more shares at the end of the five-month period. And you own more shares because, due to the consistently rising value of the fund, your friend couldn't afford to purchase as many shares as you had purchased originally. But what happens if the value of your fund fluctuates dramatically during those five months?

Continued: Different results

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