Many people get a lump sum at some point in life – perhaps you’ve inherited a windfall, received a bonus at work or have a tax-free sum from your pension. So how can you put it to good use?
Bank savings account
Traditional demand-deposit savings accounts offer liquidity and ease of access but pay low interest rates, and they may also include various fees for handling the account. You can withdraw any or all of the funds in a demand-deposit account at any time without penalty or prior notice required. However, they should generally only be used for funds you may need to access at any time, such as your emergency fund, and this is why:
A well-known, high street bank here in the UAE offers a nominal interest rate of 0.25% p.a. on its standard savings account. With inflation at 1.94% this year (2019), the real interest rate will be negative 1.69%. The same bank offers a fixed-deposit savings account, with a top nominal interest rate of 2.05% over 60 months. Even this product will barely keep you up with inflation, while tying up your capital.
So if keeping your money in a conventional bank savings account will cause a loss of the value of your savings in real terms, what are better ways of putting your capital to work?
Stocks and bonds
Fixed-income, fixed-tenure bonds generally pay you income at a specified rate on specific dates during the term of the bonds and, subject to risks set out in the relevant bond prospectus, the face value of the bonds is repaid on maturity. They’re considered low risk, but generally offer lower returns and aren’t the best way to maximize return on capital in the short or medium term.
Stocks, on the other hand, can be a mixed bag. We all know the stock market is volatile, but generally the people who lose out big are those trying to speculate. However, there are quality stocks and dividend reinvestment programs (DRIPs), which deliver good returns and absolutely belong in an investment portfolio. Picking individual stocks requires a lot of research and keeping a keen eye on the micro and macro economic factors affecting those stocks. Playing the stock market isn’t beyond our capability, but it is often beyond our capacity as it simply requires more effort than many of us have time for.
A pragmatic approach is to invest in mutual or index fund accounts, or exchange-traded funds. A fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the fund are known as its portfolio. Investors buy shares in funds. Such funds have dedicated, expert teams behind them which research individual stocks, enabling you to invest in the stock market at a significantly reduced risk profile. The asset management industry is here to help by offering a multitude of high-quality, short, medium and long-term investment portfolios.
Determining your lump sum strategy
Should you invest it all right away or in smaller increments over time, a strategy known as dollar-cost averaging? Investing a lump sum comes down to the question of your tolerance for risk.
All at once…
Research from Vanguard shows that investors would do best by immediately investing a lump sum. The simple explanation is that markets tend to go up roughly three out of every four years. Vanguard looked at a 60/40 stock/bond portfolio in the US, UK and Australia. It compared the performance of an immediate lump sum investment over a year against 12 monthly purchases spaced out over the course of a year. The lump sum beat dollar-cost averaging about two-thirds of the time and by an average of 1.5 percent to 2.4 percent, depending on the country. The results were even more pronounced for longer time horizons.
Investing all of your money at the same time is advantageous because:
- You’ll gain exposure to the markets as soon as possible;
- Historical market trends indicate the returns of stocks and bonds exceed returns of cash investments and bonds;
- When markets are going up, putting your money to work right away takes full advantage of market growth.
…slow and steady
Dollar-cost averaging is a strategy that allows an investor to buy the same dollar amount of an investment on regular intervals. The purchases occur regardless of the asset’s price. When a stock or asset is down, think of it as being on sale – your dollar buys more of it – and vice versa. Dollar-cost averaging is a tool an investor can use to build savings and wealth over a long period. It is also a way for an investor to neutralize short-term volatility in the broader equity market. A perfect example of dollar-cost averaging is its use in 401(k) plans, US retirement savings plans.
Dollar-cost averaging may be for you if you want to:
- Minimize the downside risk of a huge investment;
- Take advantage of the market’s natural volatility by lowering the average price you pay for shares;
- Avoid feelings of regret if the market takes a downturn after you invest.
…or wait and see
Delaying investment is itself a form of market-timing, something few investors succeed at.
It’s best to work with a financial advisor in order to make a savings and investment plan, to ensure your strategy meets your needs and goals. Together, you’ll consider how your finances stand, the things you hope to achieve, how you feel about money and risk, and what might be coming down the track in your life. This gives you the right information to assess and choose secure, suitable, affordable and sustainable investment products.