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Does investing monthly or annually beat a lump-sum portfolio?

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As an adviser, you want your clients to experience the best possible investing outcomes from one year to the next. One way to ensure they will see better results based on one specific metric is to encourage them to invest systematically, instead of in a lump sum.

This idea isn’t strictly about investment returns, but rather about portfolio performance. Those are two different issues.

Returns are a function of the asset allocation and fund selection, whereas portfolio performance also considers how much money the investor added during the year. Yes, it’s about optics – that is, the numbers a client actually sees on their portfolio account statement.

The optics are real, and they’re important, because we tend to believe what we see.

First, a bit of background. All reported performance data, no matter the source (Morningstar, Lipper, Bloomberg, etc.), has five built-in assumptions: (1) an initial lump sum investment, (2) no additional investments, (3) no money withdrawn during the time period, (4) no inflation and (5) no taxation.

I will demonstrate what happens when we change some of these assumptions — specifically comparing performance based on an initial one-time lump-sum investment versus that achieved when a client deposits money into their account annually or monthly.

I’m assuming many clients evaluate performance based on the change in their account value from year-end to year-end. In other words, if their account value was $1.2 million on Dec. 31, 2015, and is $1.35 million on Dec. 31, 2016, they’re likely to be happy, because the account value increased.

The optics are real, and they’re important, because we tend to believe what we see.

In fact, some clients may even do a quick calculation and determine that their account value increased by 12.5%. Assuming they don’t have unrealistic expectations of a 20% return each year, they should be pleased. Some clients, of course, evaluate performance more often than annually, but this article will focus on annual account value performance.

The investment portfolio evaluated in this study is a seven-asset equally weighted portfolio based on the actual monthly performance of seven prominent indexes from Jan. 1, 1980, to Dec. 31, 2015. Each index was assigned a 14.28% allocation (S&P 500 Index, Russell 2000 Index, MSCI EAFE Index, Dow Jones U.S. Select REIT Index, S&P Goldman Sachs Commodity Index, Barclays U.S. Aggregate Bond Index and 90-day US Treasury Bills). The performance reported here assumed monthly rebalancing.

The year-to-year change in account value in the seven-asset portfolio is illustrated in the chart “How We Invest.” Three different investment behaviors are shown: (1) an initial lump-sum investment with no additional money invested over the 36-year period from 1980 to 2015, (2) an annual investment of $3,600 made each year on Jan. 1 and (3) a monthly investment of $300 made at the start of each month.

The lump-sum investment and first annual investment of $3,600 experienced a one-year change in account value of 22.2% from year-end 1979 to year-end 1980.

The $300 monthly investment experienced a one-year change in account value of 1,256.7%.

Of course, this is an extreme case, because the starting balance was so small and the ending balance was much larger based on 11 subsequent investments of $300 in addition to the underlying investment gains.

From year-end 1980 to year-end 1981, the lump-sum account increased by only 1.3%, while the annual investment of $3,600 experienced an 84.2% increase in account value.

Again, a large chunk of that 84.2% return was the second investment of $3,600 made on Jan. 1, 1981. Nevertheless, the 1980 account statement showed an ending balance of $4,400 and the 1981 statement showed a balance of $8,106.

Optics – it’s what clients will likely react to.

The account with a monthly investment of $300 had even better performance optics in 1981, with a year-to-year change in account value of 90.7%. Again, starting from a small dollar base creates a situation where large percentage increases are possible.

The huge disparity in performance between the lump-sum account and the other two accounts begins to converge after about 10 years, as the dollar values in the annual and monthly investment accounts become larger.

These findings are important for at least three reasons.

First, clients who are new to investing often experience high amounts of anxiety regarding timing.

“What if this is a bad time to invest?” or “Maybe I should wait until the markets all drop — and then invest?”

Investing systematically not only removes the all-at-once timing risk, it also creates account value measurement optics that are always superior to lump-sum investing.

For example, in 1992, the lump-sum account for the seven-asset portfolio increased by 6.3%, compared to 9.8% for the annual account and 10% for the monthly account. Not a huge difference, but still a larger change in account value.

In 1990, the lump-sum account experienced a loss of 3.4%, while the annual investing account produced a slight gain of 0.6% and the monthly investing account had a 1.1% increase. In 2008, all three accounts got clobbered, but the annual and monthly investing accounts had slightly smaller losses compared to the lump-sum account.

The second reason these findings are important for clients to understand has a lot to do with our natural desire to see the positive results of our efforts — the sooner, the better. The impressive percentage growth in the account values of annual and monthly investing provide nearly immediate feedback that keeps the client motivated.

There is no magic here. Clearly, it is the additional money being invested into the portfolio that creates the larger percentage gains in account value, compared to a lump-sum account that never receives new money. Importantly, the more impressive percentage changes in the account value happen in the early years, when the motivation to keep investing may be most needed.

You may think the early-years advantage is a function of starting this analysis in the 1980s, when asset performance was generally good. But consider the chart “More Recently,” where we begin the investing on Jan. 1, 2000. As you may recall, 2000 was a train wreck for most equity asset classes. The S&P 500 had a return of -9.1%, the Russell 2000 was down 3.02% and the MSCI EAFE Index lost 14.17%.

Fortunately, the other four asset classes (real estate, commodities, bonds and cash) had positive returns in 2000, which resulted in the multi-asset portfolio generating a lump-sum return of 9.7%.

In 2001, things got even worse for several asset classes. U.S. large cap was down almost 12%, non-U.S. stocks shed over 21% and commodities lost nearly 32%. The seven-asset portfolio as a whole lost 6.2% (based on a lump-sum investment). In 2002, U.S. and non-U.S. equities got hammered again, and the seven-asset lump-sum portfolio had a slight loss of -2.3%.

2000 was a train wreck for most equity asset classes. The S&P 500 had a return of -9.1%, the Russell 2000 was down 3.02% and the MSCI EAFE Index lost 14.17%.

The performances of annual and monthly investing in the dismal early years (2001 and 2002) were stellar, even though the lump-sum portfolio had negative returns. The impact of adding additional money each year or month into a portfolio virtually guarantees a positive year-to-year change in account value during the initial years.

This is not the case during the latter years (as we see in 2008 and 2015). However, as already noted, the percentage change in the year-end account value when money is being systematically invested will always be better than a lump sum account that relies solely on the performance of the portfolio’s underlying investments.

Obviously, all this analysis is built upon the assumption that clients have the capacity and willingness to add additional money to their portfolio. Perhaps, after you share this research with them, their willingness will increase.

Finally, the third reason these results are important is as follows: Let’s say your client invests $300 each month into XYZ Fund. Your client’s results will always be better than the published returns (for example, on Morningstar.com) of XYZ Fund, because published returns make the assumption of a lump-sum investment.

Interestingly, systematic investing transfers some of the responsibility for the portfolio’s performance to the client, and takes some pressure off the adviser and the portfolio as the only two drivers of performance.

To be sure, the asset allocation of the portfolio is a huge driver of performance, but the way a client invests can have more impact than they might realize.

Some folks may call this dollar-cost averaging. I call it smart investing that empowers clients.

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