It's All About Timing. A Guide to Buying and Selling Funds.

Profitable investment defies logic. In contrast to, example, an action movie, you want your investments to be as dull as possible. In today's unpredictable markets, the best funds aren't the glamorous tech or aggressive growth funds, but rather staid, reliable balanced or allocation funds that are well-diversified across stocks and bonds.

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According to a number of studies, most investors have poor time when it comes to purchasing and selling mutual funds, and the more volatile the fund, the worse their timing. One of the reasons is psychological. Investors benefit more from steady-Eddie balanced funds since they do not pursue performance to the expense of their returns. "You don't get the FOMO from seeing, 'Oh, my God, it went up 60%, I better jump in,'" said Russ Kinnel, Morningstar's head of manager research. "And you don't have to panic" if a low-risk balanced fund drops by a little amount.

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2 Volatile ETFs: Beware

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One approach to assess how effectively or poorly investors trade is to look at a statistic called "investor returns" from Morningstar, which evaluates the impact of funds' cash inflows and outflows to reflect the profits investors really receive on their trades. These investor returns are then compared to the traditional return numbers of the funds.

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Trading at the Wrong Time

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The lowest performance gaps are seen in balanced allocation funds, whereas the largest are found in volatile sector funds.

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The most volatile single-sector equity fund categories, such as technology or energy, had the largest gap between what the funds produced and what investors earned due to poor trading over the 10 years ended December 31, 2021, an annualized 13.84% versus 9.59%—a 4.25 percentage-point gap, according to the most recent edition of an annual report called "Mind the Gap" from Morningstar. Equity funds that were more well-diversified and less volatile had a 1.19-point difference between fund and investor returns that was much less (15.86% vs. 14.67%). Allocation/balanced funds had the smallest difference of any type, with fund and investor returns of 9.43% compared to 8.65%, a 0.77-point difference.

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The risks are illustrated by volatile aggressive growth funds as Morgan Stanley Institutional Discovery Portfolio (MACGX) and American Beacon ARK Transformational InnovationADNPX -0.10% (ticker: ADNPX). Due to investors' enthusiasm for tech companies in 2020, both funds gained over 140%; however, they later had a collapse in 2021–2022. After the increase, a lot of investors joined. By February 28, the Morgan Stanley fund had a modest 5.7% annualized return over five years, while its investor return was -11.5%. The American Beacon fund has a similar gap: a five-year investor return of -19.7% and a less painful regular return of -0.7% for those fortunate enough to join in at the beginning of its big run-up (investor returns are measured monthly rather than daily).

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Intriguingly, an analysis found that allocation funds had a smaller investor return difference than bond funds, which are typically less volatile—1.17 points for taxable bond funds and 1.21 points for municipal bond funds. Investors panic and sell when a bond fund's principal starts to decline. In contrast, they anticipate some volatility with equities. According to Kinnel, bond fund investors often just care about collecting their bond yield and don't want anything to happen to their fund investments' capital. But that's not how things operate.

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Allocation funds, which often perform better when either bonds or stocks are out of favor, provide investors with a happy medium between equities and bond funds. Many of the "target-date funds" that investors purchase via recurring automatic contributions to their 401(k) plans are allocation funds. Depending on when an investor expects to retire, these funds divide their holdings between stocks and bonds. Investors are prevented from buying exclusively at price peaks by purchasing funds at regular intervals, or so-called dollar-cost averaging.

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You may employ this method without a 401(k) (k). Think about investing regularly in a dull low-cost fund like Vanguard Balanced IndexVBIAX +0.05% (VBIAX). While you won't hit the ball out of the park, your chances of getting struck out will be reduced.