Today, I’d like to continue our video series on How To Manage A Financial Windfall.
…and the next consideration is to Understand Your Time Horizon: The most important factor in managing money is understanding the time horizon for when the money will be needed. It sounds basic, but very often this concept is overlooked. Determine your investment strategy with the end in mind. If you need your money in the near term to make a down payment on a house, then investing in venture capital or growth stocks should be avoided. Stick to something safer, like a money market account or short-term bonds. On the other hand, if you have a multi-decade time horizon, you may wish to invest a portion of your portfolio in volatile small-capitalization growth stocks that may appreciate significantly over time. An investor’s liquidity requirements are essential to determine any investment strategy.
Another point worth noting is the Percentage of Net Worth: Objectively, the amount of new money to invest may be large, but it’s important to consider its size relative to your total savings. For example, inheriting $500,000 when you already have $2 million saved for retirement comes with different considerations than if you have $250,000 saved.
If the figure is less than 25% of your investable assets, then it may make sense to invest it all at once (after paying off your expenses) in a similar allocation to your current portfolio. It is a relatively small sum of money, stressing over when to invest it won’t necessarily change your current or future lifestyle. If these funds are more than 25% of your nest egg, then you should consider whether it makes sense to invest the lump sum or dollar cost average over time. Which brings me to my next point…
…on Investing the Lump Sum vs. Dollar-Cost-Averaging: Deciding whether to invest the entire lump sum at once or spreading it out over time relates back to time horizon and not trying to time the market. Since the market’s long-term trend is positive, mathematically the best course of action for an investor with a multi-decade time horizon, whose specific risk tolerance doesn’t indicate otherwise, may be to invest the entire lump sum immediately. This will allow them to buy at lower average prices, which may allow them to outperform a strategy of slowly adding money over time.
Psychology is also a factor in the decision. Folks who are nervous about the market and can’t stomach adding a substantial level of funds all at once may be better off setting up a systematic approach to add money to their portfolio at pre-determined intervals. Dollar-cost-averaging allows investors to get their money invested over time without letting their emotions derail their finances. While this approach may not lead to the best investment performance relative to lump sum investing, having peace of mind is also an important consideration.