Things to Consider before Investing a Lump Sum
- If you happen to have a substantial windfall in your hands, you may be wondering how to use these funds.
- You could consider depositing your funds to a bank’s current account, however, the low interest rates offered today means that your money will be worth less in the future.
- You may also want to create an emergency fund that can serve as a financial safety net for the future should any unexpected expenses crop up.
- Alternatively, a lump sum could serve as a good means to pay off any debt you may have.
- Decide whether you would like to invest the money all at one go or invest smaller amounts over a long period of time known as pound-cost averaging or drip-feeding.
- Although drip-feeding could offer a layer of protection from risk, ultimately your returns are likely to be lower than a well-placed lump sum.
- You must also determine whether you are looking to acquire capital growth or for income.
- No investment can take place before you establish your risk tolerance. Whether you fall under low, medium or high risk, it is important to understand the difference between each one so that you can maximise your return without risking it all.
- The place where your assets like bonds and stocks are held, your portfolio can be either one of growth, income or value depending on the investment strategy that will be used. Irrespective of your choice, make sure that your portfolio is diversified enough.
- Unsure as to how to go about investing your lump sum? Seek professional advice from a reputable financial advisor. CC’s investment advisors can offer you customised financial guidance based on your goals and create a tailor-made portfolio that can address your unique needs.
Whether you have inherited a large sum of money, sold some assets and have a large amount of proceeds on your hands or you have hit the lottery jackpot, you are probably wondering what you should do with all this money. Your first instinct may be to spent it to your heart’s desire, but would it not be best to put it to good use?
Your proceeds can help you gain a fresh perspective on your financial objectives and dreams, while it can also drive you to fine-tune your financial strategy, not to mention that there are several ways you can maximise this lump sum further.
So whether you are a seasoned or a novice investor, here are a few basic things to consider before deciding on how to best invest your new found-wealth.
What to do with the money as soon as you receive it?
Make a deposit
Probably one of the first options that crop to mind when considering what to do with a lump sum of money is to deposit it in your bank’s current account until you decide what to do with it. However, when considering the low interest rates offered by banks today which are typically lower than inflation – the rate at which money loses value – this means that your money will be worth less in the future than it is now and as a result you lose your purchasing power. You may be better off transferring it to an instant access savings account that pays a higher rate of interest.
Create an emergency fund
A personal budget set aside to serve as a financial safety net for future mishaps or unexpected expenses, an emergency fund can be a lifesaver when your car requires some costly mechanical work, you have a leaky roof to repair, a debilitating illness that will require private medical attention or you are suddenly left without a job. Setting funds aside for emergencies will prevent you from having to resort to high-interest debt options like credit cards or to use money intended for a different purpose like your retirement or your children’s education.
Pay off your liabilities
Your lump sum could be used to pay off some or all of your debt. This will depend upon a number of factors, such as the amount you have inherited, the outstanding debt and the interest rates you are paying on any of these liabilities. For instance, if you have a balance on a credit card which you have not been clearing each month, it is likely that you will be paying a high interest rate. Liquidating this liability would be a good idea. On the other hand, if you have a loan with a lower interest rate it might be wise, for instance, to invest in an investment grade bond which will return a higher income than your loan liability, leaving you with surplus cash in hand.
Investing your money
If you have taken your goals into consideration and you have been diligent with your finances so that you do not require an emergency fund or to use the capital to pay off any debt, then investing your lump sum can help you increase your wealth further. But should you invest all your money at one go or go for the pound-cost averaging strategy?
Investing lump sum versus pound-cost averaging
Perhaps one of the most common questions individuals who have just received a large amount of money often need to ask themselves is whether they should invest it all right away or in smaller amounts and over time in a strategy known as pound-cost averaging. Also known as drip-feeding, this consists of placing funds or capital in the market in small amounts and over a longer period of time as opposed to injecting a large lump sum at the start and holding it for a number of years.
Particularly appealing to those who can only afford to make small monthly investments, drip-feeding investing may offer a layer of protection from risk but this also means that your returns are likely to be lower than a well-placed lump sum. In addition, it may be difficult to decide how much to invest every month when considering that the longer your money sits in an account, the more inflation will eat up into your purchasing power, leaving you with a smaller net worth.
Decide between capital growth or income
Something else you need to decide on is whether you wish to invest the funds for capital growth or if you need to earn an income to supplement your existing one. Capital refers to the initial sum invested, so capital gain is any profit gained when an investment is sold for a higher price than that it was originally purchased. In contrast, investment income is profit that comes from things like interest payments, dividends or capitals gains acquired from selling a security or an asset, as well as any profits made through any type of investment vehicle.
Understanding the difference between these two is important since your decision will affect everything ranging from your retirement strategy to filling your taxes.
Determine your ideal term of investment
Both short and long-term investments have their pros and cons and knowing when to use each one is part of growing your wealth and reaching your financial goals. As expected, long-term investments are those that you can keep for a long period of time. These are known for providing opportunities for growth in your portfolio since you cannot access the money for a significant period of time and therefore, they are left there to grow. Long-term investments are particularly ideal if your retirement is more than 20 years away, you want protection from inflation or you need a financial plan that covers the next seven to 10 years of your life. In contrast, opt for short-term investments if you think you will be needing the money soon or you are looking for a regular source of income.
If you are only prepared to invest for the short-term, fixed term investments such as bonds or treasury bills are a good choice. Medium and long-term bonds are also available and these offer more flexibility as opposed to fixed deposits and structured guaranteed products where the investor cannot sell for a stipulated period of time – for instance, five years – without incurring heavy penalties.
Irrespective of your choice, make sure you have clear answers to these common questions before making any investment.
Establish what your attitude towards risk is
All investments involve some element of risk, so much so that it is fundamental to investing. In financial terms, risk refers to the degree of potential loss or uncertainty that is inherent with an investment decision. Generally speaking, the higher the risk, the higher the potential returns, so risk is a major factor in determining where your lump sum should be invested.
If you are new to investing, you may find it difficult to determine just where the risk really lies and what the differences between low, medium and high risk are. There are four basic levels of investment risk as far as your capital is concerned and the differences between each one include how readily you can get your money when you need it, how fast your money will grow and how safe your investments are.
No Risk – Cash, bank savings accounts
Low Risk – Government backed securities such as government bonds
Low to Medium Risk – Investment grade bonds like corporate bonds
Medium Risk – Shares in major companies such as those known as blue-chip companies
High Risk – Shares in companies or instruments where there is large volatility in the share price like shares in smaller companies or companies involved in oil exploration or pharmaceutical research that are dependent on making a discovery to succeed.
Select the type of portfolio
Your investment portfolio is where your assets like bonds, stocks, currencies, cash and cash equivalents. Portfolios come in various types depending on the investment strategy that will be used. Broadly speaking, here are three types of portfolios:
- Growth portfolio – as the name implies, this portfolio aims to promote growth by taking greater risks like investing in growing industries or newly-established companies that have more potential for growth.
- Income portfolio – this type of portfolio is focused on securing regular income from investments as opposed to centering on potential capital gains. One way this is done is by purchasing stocks based on the stock’s dividends rather than on a history of share price appreciation.
- Value portfolio – with such a portfolio an investor usually takes advantage of buying cheap assets by valuation. In other words, it seeks to invest in bargains in the market. Investors look for companies with profit potential but which are currently priced below their fair market value.
As an investor, you also have the option to mix your investments to mitigate the risks. For example, if may opt to invest your funds in shares of major companies which are considered of medium risk or invest some funds in Government-backed securities which are typically regarded low risk and some funds in the shares of smaller companies which are of a high risk. In this manner, your portfolio becomes a medium risk one. On the other hand, if you invest in low risk bonds and in blue-chip shares which are of a medium risk, then the end result would be a low to medium risk portfolio.
You may also want to consider investing in various companies from different sectors, such as banking or technology, while alternatively, you may want to invest in different stock markets around the world to further spread the risk. This technique of spreading your investment across a range of companies, sectors, geographical locations and assets is known as diversification. Ideal for reducing your portfolio risk and preventing it from taking a big hit should markets swing one way or another, you have a greater chance of maximising your return since you are investing in different areas and you do not have to rely on a single investment for all your returns. Read about the importance of having a diversified portfolio.
From gaining instant exposure to the markets to being able to take full advantage of market growth when markets go up, there are several benefits to investing a lump sum. For instance, it offers further simplicity since you invest once and then you can sit back and watch your investments grow, making it ideal for individuals who prefer to invest long-term. At the same time, since lump sum investments are made once, they tend to incur minimal charges and lower maintenance costs when compared to periodical investment. Lastly, a lump sum investment has enough time to grow in the market, which also means that it has sufficient time to adjust to any market changes.
Having said that, always bear in mind that whether you opt for low, medium or high-risk investments, there is always an element of risk involved. As a result, you should consider your investment objectives, your appetite for risk and your investment tenure and although the general theory is that the greater the risk, the greater the potential gain, it could prove to be the opposite most especially if you are a novice investor and you do not seek professional advice.
If you are unsure whether investing a lump sum is the ideal option for your circumstances or perhaps you are uncertain how to go about it, seek professional advice from a reputable financial advisor. If you would like personal and highly customised financial guidance based on your goals, it is time to speak to one of CC’s investment advisors. Qualified and experienced, our financial investors work with tailor-made portfolios and are able to address clients’ unique needs, while with direct access to the markets, they can assist you in the best possible way without being restricted to recommend any particular investment.