6 Things To Consider When Investing a Lump Sum
You’ve just received a lump sum of cash. Perhaps it was from a rollover retirement account, the sale of assets, or an inheritance. Now what do you do? Your first thought may be to spend it. That’s always an option – and probably the most fun option. The less-fun decision is to invest it. This is especially less fun if you’re unfamiliar with how all that works. It’s no wonder one of the most frequent questions I am asked is how to invest lump sums of new cash.
One of the first decisions to make is whether to invest the proceeds all at once or over time using dollar-cost averaging (DCA). This is a strategy where you invest equal parts based on preplanned intervals. Here are four simple questions to ask yourself, to help you decide which strategy or combination of strategies may be right for you.
- What is the size of the cash lump sum relative to your existing savings? If it is relatively small, regardless of where it came from, I suggest investing it all at once and being done with it. My rule of thumb is 20 percent. If a lump sum is 20 percent or less of the amount you have already saved, then invest the entire amount in your existing asset allocation. For example, if you already have $1 million in savings and you inherit another $200,000 or less, put it all into the allocation at one time. If the lump sum is greater than 20 percent, proceed to #2.
- Was this money from an employer pension plan? If the answer is yes, then the cash was most likely recently invested in stock and bond investments, which means it probably is best invested right back into the same. For example, if your 401(k) was recently invested in stock and bond funds or a balanced fund before it was liquidated to cash for the distribution, then the cash should go right back into a stock and bond allocation that’s right for your long-term retirement needs. If you’re not sure about your allocation, the distribution may serve as an excellent time to be in touch with an objective investment advisor, to help you determine where you stand, big-picture.
- Was the money from the sale of a business or property? If the answer is yes, then there was a previous business risk attached to that money, even though it wasn’t direct stock market risk. In this case, consider investing a portion of the money in an allocation of stocks and bonds based on your needs and DCA the remaining over a period of time, perhaps two years. This spreads out the entry-point risk into the markets. If your timeframe and risk tolerance are such that you can calmly stay the course through volatile markets, then you could put the entire amount to work for you as soon as possible, to give it more time to earn the market’s expected long-term returns.
- Was the money inherited, won, or from another source where you had no previous ownership? Here is where DCA can again work well for many investors. You might consider investing a portion of the funds now and DCA the rest over a few years. For example, imagine you won $1 million after-tax in a lottery. By investing $400,000 this year and $200,000 per year for the next three years, you can spread out your entry-point risk.
The guide above provides some ideas for the timing of lump-sum investing, but it doesn’t address where to invest it. That depends on your financial situation — although receiving a lump sum often changes that. Here are a couple of guides to help with investment decisions:
- If the lump sum is 20 percent or less of your current savings as described in #1, then your asset allocation shouldn’t be affected, at least not by the new cash in and of itself. Simply invest according to your current investment policy (or establish one if you’ve not yet got one).
- If the lump sum is more than 20 percent of your current savings, then you should consider reviewing and revising your overall investment strategy. You may be able to do this on your own by reading investment books, or you can get help from a trusted investment advisor. Another idea is to visit www.Bogleheads.org and learn from this free online community of individual investors.
Receiving a lump-sum distribution doesn’t need to be overly daunting. It can even serve as a good time to take a fresh look at your financial goals and dreams, and fine tune your strategy accordingly. The points above can help you get started. Continued education and investment advice as warranted can keep you on course from there.