Investing Classroom: Methods of investing in funds

It's hard enough to decide whether or not to invest with an adviser and to commit to a 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 favourite 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.

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 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 or all cash. 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 stock market. 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, 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.)

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.

Here's an example. Say you decide to invest an amount of £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. So, say that your lump sum investment of £10,000 buys you 5,556 shares at £1.80 per share, while your friend purchases 1,111 shares at £1.80 each in the first month, followed by 1,099 shares at £1.82 the next, then 1,081 shares at £1.85 in the third, 1,070 at £1.87 in the fourth and, finally, 1,053 at £1.90 apiece with his last £2,000.

You will end up ahead after five months, with 5,556 shares worth a total of £10,556, 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 originally purchased and so he ended up with a total of 5,414 shares worth £10,287 in total. But what happens if the value of your fund fluctuates dramatically during those five months?

-------------Your investment--------Your friend’s investment

Month 1----5,556 shares at £1.80-----1,111 shares at £1.80

Month 2----N/A---------------------------1,667 shares at £1.20

Month 3----N/A---------------------------1,081 shares at £1.85

Month 4----N/A---------------------------1,481 shares at £1.35

Month 5----N/A---------------------------1,053 shares at £1.90

Total-------5,556 shares----------------6,393 shares

End value--£10,556----------------------£12,147

In this case, your friend ends up in the lead. By investing a fixed pound amount in the fund every month, your friend bought more shares when the price was low, fewer shares when the price was high, and ended up with more shares after five months.

To be sure, such drastic fluctuations in NAV are rare. Because the stock market generally goes up more often than it goes down, most investors will receive the best long-term results by lump-sum investing.

Why pound-cost average?
Investing in dribs and drabs may not be the path to greater return, but we still think pound-cost averaging, or investing a set amount on a regular basis, is a great method of investing. Our argument for pound-cost averaging has a couple of dimensions. First, it can reduce risk. If your fund declines in value, the worth of your investment is less, even though you still own the same number of shares. In the same way that pound-cost averaging will net you more shares in a declining market, it can curtail your losses as the fund goes down.

The second reason we like pound-cost averaging is that it instills discipline. Investors often chase past returns, buying funds after a hot performance streak. And they'll sell funds when returns slow or decline. Bad idea: That's a form of market-timing. But pound-cost averaging prevents you from market-timing, because you're buying all the time. Heck, you may even forget that you're investing if you set up an automatic-investment plan with a fund family.

Which leads us to the final reason we love pound-cost averaging: It's a crafty way to invest in some great mutual funds that might be inaccessible otherwise. Many fund companies will waive their minimum initial investment requirement if you agree to set up an automatic-investment plan and invest a little each month or quarter.

Decision time
While market-timing is out of the question for all investors (but some still try), whether you invest all at once or a little at a time depends on how much time you have to invest and whether your primary goal is maximising return or minimising risk.

The shorter your time horizon, the greater chance you take of losing money with a lump-sum investment. However, if you had £20,000 to invest, it probably wouldn't make much sense to invest £1,000 per year for the next 20 years. Over long time frames, funds go up more often than they go down, and when they go down, they eventually bounce back. It is almost certain that the NAV you would pay 10 years from now would be higher than the NAV you would pay today.

We suggest combining the two strategies: Invest as much as you can today and vow to invest a little more each month or quarter. That'll keep you disciplined and have you investing right away.