How to Invest a Large Lump Sum of Money Wisely

A Sense for Money

This column has staunchly recommended the discipline of regular savings along with the financial benefits that this brings, such as dollar cost averaging. There are, however, times when individuals have a large sum that they wish to invest on a lump sum basis. The source of the funds could be a maturing policy, an inheritance, a retirement account, a big bonus or share options. But let’s just use our imagination and assume you have a sum of US$ 100,000 that you want to invest today.

If you want to invest US$ 100,000 in professionally-managed funds then you will be faced with a bewildering array of choices. At one extreme, there are cash funds where your capital is fully secure, but returns are unexciting – it takes you a long time to double your money with a cash fund. At the other extreme, there are equity or commodity funds where you can double your money within a year or so if things go well. Of course, with such risky funds you can also halve your money very quickly and there are absolutely no guarantees.

The following highlights these extremes, and also includes two other fund types with characteristics somewhere between cash funds and equity funds:

Fund Type          Return/Reward        Risk
Cash                    Low                          Low   
Bond                    Medium                    Medium
Balanced*            Medium                    Medium
Equity                  High                          High

*A balanced fund normally comprises a mix of cash, bonds and equities

This is a perfect illustration of the classic risk-reward dilemma that high returns are normally associated with high risk. Now we all know this already: When someone offers us an investment where the return looks too good to be true, it normally is too good to be true. “Where’s the catch?” is how most of us respond. Often the catch is that your capital is at risk.

Therefore you need to decide where you sit on the risk-reward spectrum and then make your choice. If you are young, can take a long term view and can afford to take a loss in the short term, then equities are probably best. If you are retired, need security and cannot afford to take a loss, then a more secure fund choice is best.

As an alternative, some funds are now available which give you the best of both worlds. With these funds you enjoy equity exposure along with capital security. Imagine you invest your $100,000 in one of these funds and choose a ten year term. The fund manager will take your money and put a portion in ten year bonds and a portion in equities. The portion in bonds is carefully calculated so that after 10 years it will accumulate to $100,000. This assures your return of capital after 10 years. The portion invested in equities is then the “icing on the cake,” and it could be either a very thin layer of icing or a very thick layer of icing, depending on how the equity markets perform over the ten years. But the key point is that the bond portion always gives you the comfort that, come what may – and even if the equity markets totally crash – you will always get back at least your initial capital.

There are variations to the approach, where the fund managers “leverage” (borrow money) to give the fund even higher equity exposure. There are also funds which periodically lock in the gains of the equity portfolio – this avoids you losing out if the market crashes just before the end of the term. The latter funds are known as “high watermark” because you get the benefit of the highest equity price during a period rather than the value at the end, which could be lower.

So there are some ways in which you can have you cake and eat it. You can enjoy the exposure and rewards of the equity market and rewards while keeping your capital secure. These types of fund have only recently become available and are certainly worth considering. You could try to use the portfolio techniques yourself to get the benefits of capital security and high watermarks, but frankly it is best left to the professionals. They adjust and re-balance the portfolios, often on a daily basis, to make sure all is on track. Part-timers really do not have the time, let alone the skill, to do this properly.

Now the bewildering array of choices does not just apply to products, but also to financial advisers and to fund managers.

In a later post, we will discuss how to choose a company and how to select a financial adviser.