Standing at the precipice, the cash-laden investor turns to the aged guru and asks quietly, "Is now the time to get back into stocks?" After a thoughtful pause, the guru utters one word: "Depends." The investor stands motionless, awaiting the sage. Finally, the investor asks the obvious question, "Depends on what?" "How you get back in," the guru whispers.

Consider the guru's advice. For investors who exited their equity-based portfolios at some point and are now thinking of moving from the sidelines, there are basically two approaches: jump in all at once (lump sum) or ease in by degree (systematic investments each month or year). The past three years-2008, 2009 and 2010-present an interesting time frame in which to study these two reentry options.

**TAKING THEIR LUMPS**

In 2008, U.S. equities were gutted. In fact, 99.8% of all U.S. equity mutual funds had a negative return. This performance figure is drawn from the universe of distinct (i.e., only one share class per fund) U.S. equity mutual funds that have no more than 15% of their portfolio in cash, bonds or non-U.S. stocks-2,391 funds in total.

The average return for all these funds in 2008 was -37.8%. The worst return was -77.6%, and the best was 10.2%. But only four funds in this universe had a positive return.

In 2009, everything changed. Indeed, 99.5% of U.S. equity funds had a gain. The average one-year return was 32.4%. In 2010, the equity party continued, with 99.8% of the funds delivering a positive return. The average return in 2010 was 19.6% for the same group of funds. By the end of last year, it might have seemed reasonable to assume that the damage incurred in 2008 had been rectified. That is, funds that were beat up in 2008 are now whole after two solid years of positive returns.

Although that might seem reasonable, the concept is largely incorrect. Assuming a single $10,000 investment at the start of 2008, only 38.8% of the 2,391 funds produced a positive three-year annualized return by the end of 2010. That means more than 61% of the funds in this U.S. equity universe were still under water at the end of 2010 (see "Little by Little," on page 128).

Assuming that single initial investment of $10,000, the average three-year annualized return among this universe of funds was -0.9% (the median three-year annualized return was even worse at -1.3%). The average balance at the end of 2010 based on a $10,000 investment on Jan. 1, 2008, was $9,803. The largest ending balance was $22,142, while the lowest was $4,472.

Even after two great equity years, the majority of equity funds still had not recovered from the losses of 2008. Recovering from a huge loss can take years-and that's only considering the mathematics of financial recovery. Emotional recovery is tougher to quantify.

**ADDING OVER TIME**

There's an interesting twist to the past three years. The percentage of funds (noted in the chart above) that failed to produce a positive return from 2008 to 2010 is based on a common assumption-that of a lump-sum investment at the start of the period in question. In fact, it is this assumption that drives all of the reported performance data for stocks and mutual funds. If we change that assumption, the results are dramatically different.

For example, let's assume a client invested $10,000 systematically over the three year period. That is, he or she invested $3,333.33 at the start of 2008, added another $3,333.33 at the start of 2009 and then added the final $3,333.33 at the start of 2010.

This investing scenario essentially models an IRA investment in which the client makes an annual investment into his or her retirement account. In essence, the investor dollar-cost averaged during the three-year period of the experiment.

Under this systematic investing assumption, 99.3% of all the funds had an ending account balance in excess of $10,000 by the end of 2010. The average ending balance was $12,543.

The average three-year return for the dollar-cost averaging equity reentry approach from Jan. 1, 2008, to Dec. 31, 2010, was 11.6%. This outcome is quite different from the average three-year annualized return of -0.9%, assuming a single initial investment of $10,000. Interestingly, all reported performance figures (Morningstar, Lipper, etc.) are based on a single lump-sum investment.

Now consider another method of investing-monthly deposits into a 401(k) account. This may be the single most common way that people actually invest. This analysis assumes a monthly investment of $277.78 into each of the 2,391 funds starting on Jan. 1, 2008, and ending in December 2010. There were a total of 36 monthly investments over the three-year period for a total investment of $10,000.

The average three-year annualized return for all 2,391 U.S. equity funds was 14.9% and the average ending account balance was $12,725. A total of 2,383 funds (99.7%) had an ending balance in excess of $10,000.

Thus, how money was actually invested during 2008, 2009 and 2010 had a huge impact on the outcome. In only about 39% of the cases did a lump-sum investment at the start of 2008 arrive at the end of 2010 with a balance exceeding the initial investment. In contrast, systematic investments during the three-year period (either annually or monthly) produced a higher ending balance than the amount invested in more than 99% of the funds.

**FIRST-YEAR BLUES**

What conclusion should we drawn Are lump-sum investments risky? Such a move is clearly exposed to timing risk.

Over the past three years, we saw that an initial investment was at risk if it experienced a major loss in the first year. Even two strong subsequent years were not enough to restore the initial investment to its starting point a majority of the time.

A safer approach (admittedly with perfect hindsight) would have been to reenter the equity market gradually, such as on a monthly basis. Obviously, a lump sum is preferable if the investment enjoys only positive returns over the subsequent years. But we put money into equity investments knowing that they do not produce positive returns every year.

In fact, if we look back to 1926, we see that the S&P 500 produced positive annual returns 70% of the time over the past 85 years. That means there's a 30% chance a lump-sum investment will take a hit in the first year. Complicating matters is the fact that U.S. equity (as measured by the S&P 500) sometimes experiences several negative years in a row.

Over the past 85 years, the S&P 500 had 61 positive years and 24 negative years. However, on multiple occasions the negative returns were bunched together (1929-32, 1939-41, 1973-74 and 2000-02). These four periods of bunched negative returns represent half of all the negative returns during the past 85 years. That means the math looks like this: We face a 30% chance of a lump-sum investment experiencing a loss in the first year and a 15% chance (50% of the 30%) of the lump-sum investment incurring a multiyear loss.

**DELIVERED WISDOM**

We find ourselves back on the mountain asking the guru yet another question. "Does the length of our intended investment horizon affect the lump-sum decision?" In other words, if we intend to invest the money for a minimum of 10 years as opposed to just three years, do we remove some of the timing risk?

"Of course it does," the investment guru murmurs. "How long you intend to stay invested affects your decision of how you invest."

So let's put the guru's philosophy to the test by comparing a lump-sum investment method versus an annuity investment method over different time frames. In our analysis, we will use the S&P 500 as the sole investment choice.

And we'll examine two specific time horizons: three-year investment periods and 10-year investment periods. Since 1926, there have been 83 three-year rolling periods and 76 10-year rolling periods. The lump-sum investment consisted of a $10,000 investment at the start of each separate three-year period and each separate 10-year period.

The annuity investment method consisted of a $3,333.33 investment at the start of each year during each of the 83 three-year periods, and a $1,000 investment at the start of each year for each of the 76 separate 10-year rolling periods. Here are the results: Between 1926 and 2010, a lump-sum investment method ("all at once") outperformed an annuity investment method ("by degree") in 78% of the 83 three-year periods. But over the 76 rolling 10-year periods, a lump-sum approach outperformed an annuity investment approach 91% of the time.

The guru was right. However, over the past 10 years (2001-10), a lump-sum method outperformed an annuity approach only 50% of the time (when calculating results using three-year investing periods).

As we trudge down the mountain, we realize the guru overlooked one additional issue that affects our choice of investment technique, namely the degree of diversification of the intended investment. Thus far, we've only examined a 100% stock portfolio, the S&P 500.

Let's consider what happens if we build a simple two-asset portfolio consisting of 60% U.S. stock and 40% U.S. bonds-the classic and simplistic balanced portfolio. Since 1926, investing in a 60/40 portfolio using a lump-sum approach outperformed an annuity investing approach 82% of the time (using three-year holding periods), and 93% of the time if investing for a 10-year period.

Not huge differences (82% vs. 78% and 93% vs. 91%), but increases in the likelihood of success nevertheless. By building more diversified portfolios that include more asset classes, we increase even further the probability of an all-at-once investment technique faring well.

**MINIMIZING TIMING RISK**

As demonstrated, a lump-sum investment creates timing risk, namely that our entire investment will get hammered if the investment suffers a big loss in the first year or two. One approach to minimize that risk is to ease our way gradually into equity investments by periodically investing, such as annually or monthly.

Another way to minimize the timing risk inherent in a lump-sum investment is to lengthen the investment holding period (thus, giving it more time to recover if a major loss does occur) and to build a more diversified portfolio that lowers the probability of experiencing a large loss. Yet another approach is to split the intended investment into a lump-sum portion and an annuity portion-and commit to using both approaches simultaneously.

Regardless of which approach we choose, we must resist the ever-present urge to second-guess ourselves. By definition, the process of investing involves uncertainty and, therefore, risk.

For the most conservative clients, the most prudent way to reenter the equity markets is by degree. For investors with well-diversified portfolios and lengthy holding periods, a lump-sum approach will likely produce better outcomes.

*Craig L. Israelsen, Ph.D., is an associate professor at Brigham Young University, designer of the7Twelve Portfolio (www.7TwelvePortfolio.com) and author of 7Twelve: A Diversified Investment Portfolio with a Plan.*

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