I’m a member of several online investing and personal finance groups, and recently I’ve noticed several people asking questions about how to invest a large chunk of cash.
This cash could come from a number of different places, including an inheritance, a bonus at work, or the sale of a business. But in this situation, a member asked the following question:
“I am selling my first house and we close next Friday. That means that shortly after, I will have a decent chunk of change to invest. I currently have a solid emergency fund, and I am on track to max out my 401k this year. I have a brokerage account with Vanguard, that I periodically send money to and invest in their ETFs. My wife and I will not be looking for a new house until she’s out of graduate school, 4(ish) years from now. We’re going to rent a place … So we’re basically saving up for a larger down payment on our next house. That’s my goal for the next 4 years. Large down payment on a new house.
My question is, what would you guys suggest I do with the lump sum I’m about to come into? Should I dump it into my Vanguard account and spread it across all my current allocations?”
This is a great question, and the bottom line is that the answer depends on the amount of money you will receive, your time horizon, and your ability to take on risk.
Generally speaking, most financial advisors recommend keeping your money out of the market if you will need it within 5 years. The rationale is that if the market crashes, it may take at least 5 years for the market to recover. If you will need your cash before the market recovers, then you could be SOL.
Let’s look at each of the factors for you to think about one at a time.
- 1 The Amount of Money You Will Receive
- 2 Your Risk Tolerance
- 3 Your Time Horizon
- 4 How to Invest… What the Bearded Money Guy Would Do…
- 5 Feel Like Getting in Touch?
The Amount of Money You Will Receive
The first factor to consider is the amount of money you will receive. The more money you will receive, the more you stand to lose by not having those funds invested. (And the definition of a “lot” of money is relative to your personal situation). This is what is called, in economic terms, your “opportunity cost”.
So for example, if you will receive $10,000, it’s possible you could replace those funds within 5 years if you needed to. (By investing $150 at 5% annual interest, you would have $10,200 in 5 years). But if you were receiving $500,000, then it’s much less likely that you could replace those funds.
Another consideration is the amount of passive income you could receive by investing these funds. Assuming a modest 4% interest rate, a $10,000 investment would return $33 per month in interest, or $400 per year. This may not seem like a lot of money, but over 5 years it could add up. In addition, if you were receiving closer to $100,000, then the interest payments would be over $330 per month (or $4,000 per year).
Your Risk Tolerance
How would you feel if you lost 10 or 20 percent of your investment? What about 50%? The lower your ability to tolerate risk, the safer the investments you should consider for short term (i.e. less than 5 years) time frames.
Your Time Horizon
As I’ve already said, if your time horizon is 5 years or less, most advisors would caution you against investing your money at all. By leaving your money in cash, you are sure to have the amount you need in 5 years. But you will also lost any passive income or potential appreciation that would have been available to you over those five years.
How to Invest… What the Bearded Money Guy Would Do…
Invest in Yourself
Personally, I would invest some of that cash into me and my business. That’s the best return on investment I could ever receive. If you need some additional ideas on how to earn some extra cash on the side, click here.
Now, if you have never owned a business before, and you are new to this whole entrepreneurship thing, then investing the entire amount into yourself may be a shot in the dark. (And it might also cause some friction with your significant other).
But if you do have some experience running your own business, and you know what you are doing, then using some of this money to invest in an ad campaign, some education, or even a new staff person (could be virtual) to help you grow your business may be a smart investment.
Here’s Some More Traditional Advice (Yawn…)
So I’ve already told you the same advice that you would get from most advisors. And that advice is this, don’t invest any money you would need in 5 years or less.
For me personally, that is too long of a time horizon for two reasons. First, there are many relatively “safe” investments that you could consider and still receive a decent return, even with a shorter time frame. I wouldn’t necessarily put those funds into individual stocks, or even an index fund, but shorter term bond funds may be attractive.
Second, the opportunity cost of not having that money invested is just too great in my opinion.
So what should you look for in short term investments? Here’s a short list.
Short Term Funds
When you are doing your research, you should look for “short term bond funds” with a duration of around 4-5 years (based on a five-year investment time horizon). Both Vanguard and Fidelity have a number of good options.
Keep the Expense Ratio Down!
I would also look closely at the “expense ratio”. This is the percentage of the funds operating expenses stated as a percentage of the fund’s total assets. You should scrutinize an expense ratio higher than 50 basis points (0.50%). Many Vanguard funds will be in the 5-20 basis points range, which is excellent.
No Transaction Fees
Finally, make sure there is no transaction fee involved in purchasing OR selling the fund. Many funds that charged these fees have gone the way of the dinosaur, but there are still some out there, so be careful. Once again, Vanguard funds are among the least expensive funds out there.
Investment grade government bond funds will have lower returns and will be generally safer than high yield bond funds, which invest in corporate securities that aren’t as safe.
Generally speaking, the safer the investment, the lower the return that you can expect from that investment. And the more risk you take on, the higher your expected return.
Personally, if I knew I wouldn’t need the money for at least five years, I would probably divide the funds between a short-term corporate bond fund and a stock market index fund. That way I wouldn’t get killed if we have another bear market, but I could still participate in some of the upside if the market has a sustained rally.
Feel Like Getting in Touch?
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