Market-Timing Mutual Funds

One route to investing in mutual funds is 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.

The problems with market-timing

As you can probably sense, market-timing can be problematic. Evidence suggests that it often 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.

Results from an experiment

Chalk it up to the cruelty of mathematics, as illustrated in an experiment conducted by Morningstar. It 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 the experiment, Treasury bills). A market-timer who picked the better performer half the time still ended up way behind the market after two decades. The study 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.

Why?

This is largely because over time, 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 strong 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.)