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Investing A Lump Sum Without Fear

54889279 - closeup up of dollar banknote pile I’ve mentioned before that the biggest fear for many people in their retirement planning is running out of money before they die. But another big fear, a fear that gives me job security, is the fear of having more than enough money to retire comfortably, and doing the wrong thing with it.
 
This was the fear that sent one couple, who we will call Sam and Ginny, into my office last week. These folks are just solid, middle class, hard-working folks. Sam is about 58 and is an electrical contractor in Sandwich. Ginny is 56. They have been married for 35 years and have three children. They are very proud of their kids. All three are college graduates and, as Ginny said to me proudly, with zero debt.
 
Ginny has always been the chief financial officer of their household and, frankly, has done a pretty good job. They have built their own wealth, having come from modest means. But, she admitted, she now needs help, since she feels like she is in over her head.
 
You see, Sam’s mother just passed, leaving a sizable estate to her three children. Sam’s share is approximately $300,000. Ginny said that the money is burning a hole in Sam’s pocket, but they aren’t sure what they should do with it. If they do not come up with a plan soon, Sam is threatening to buy a new Corvette—something he has always wanted to do. Ginny does not think that is a good plan, but, she is very concerned about the markets right now and does not want to invest it all and then lose it, like they lost in 2008.
 
Ginny had heard in the past that it is not wise to invest a large sum of money all at one time. She was vaguely familiar with the term “dollar-cost averaging.” Investopedia defines dollar-cost averaging as “an investment technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price.” The thought is that if you have a large sum of money (an inheritance, for example) and you invest all of that money in a single investment at one time, and it happens to be the wrong time, you could lose a significant amount of that money all at once if the market drops. If, on the other hand, you invest a fixed dollar amount on a systematic schedule, you hedge your risk by buying larger amounts of an investment when the share price is low and less when the share price is high. Ginny likes this investment technique because she feels it is less risky than investing everything all at once.
 
Seems safe, right? Not so fast!
 
Folks, I find that many people who make decisions on emotion without having a sound investment policy will choose this option. But you, Cutter Family Finance readers, know better than to base your investment decisions on emotions. Your decisions are based on facts and logic.
 
I am going to share with you the advice I gave Ginny and Sam. The first step in creating any sound investment policy is to quantify your risk tolerance and compare that to the actual risk within your current portfolio. I brought Ginny and Sam through a comprehensive process that quantifies their risk tolerance in a range from 1 to 100, with 100 being most risky and 1 with virtually no risk.
 
We determined that Ginny and Sam’s risk score in their current brokerage portfolio is a 96. However, when we assessed their risk tolerance, or the amount of risk that they are willing to accept . . . get this, it came in at a 62.
 
We had a problem.
 
Folks, if you do not know your risk tolerance, you need to figure that out, sooner rather than later. And, if you are using a financial professional or even if you are a “do it yourselfer,” you need to ask those hard questions. I explained to Sam and Ginny that regardless of what they do with the inheritance, they need to align their current portfolio with their risk tolerance.
 
Next, I had to help Ginny and Sam understand the differences between their outdated brokerage buy and hold investment “strategy,” and strategies with downside risk management. The buy and hold approach just, well, holds on for dear life in good and bad times. The philosophy behind strategies that manage downside risk is that if you can minimize losses based upon quantitative data, the upside will take care of itself when momentum is on their side.
 
After concluding that downside risk management is essential in these challenging markets, I showed Ginny and Sam how they would invest in a strategy that properly correlates to their risk tolerance, through dollar cost averaging or as a lump sum.
 
Let’s argue that Sam and Ginny’s portfolio, based on a risk analysis, should be a mix of stocks and bonds. For the sake of math, let’s go with 60 percent stocks and 40 percent bonds. If we use the dollar-cost averaging method of investing, their goal could be to have all $300,000 invested by year’s end, investing $25K a month.
 
So at the end of the third month, they would have $45K in stocks, $30K in bonds, and $225K still sitting in their savings account (earning a paltry interest rate). So, looking at their portfolio as a whole, that investment mix would be just 15 percent in stocks, 10 percent in bonds and 75 percent in cash after three months. Using this approach, even half a year into it, the mix would be 30 percent stocks, 20 percent bonds, and a whopping 50 percent still in cash.
 
This would continue to slowly balance itself out, throughout the year, until finally, an entire year later, they would have achieved their intended investment mix of 60 percent stocks and 40 percent bonds with, $180K in equities and $120K in fixed income. So, they would have wasted a good part of the year with their portfolio invested in a mix of asset classes that does not match their risk tolerance or investment goals. Their money would have been much more conservatively invested than they have determined is right for them.
 
Alternatively, as I explained to Sam and Ginny, they could invest the entire inheritance, all at once, and let that money go to work within their portfolio right from the start. For Sam and Ginny, this means $180K in stocks and $120K in bonds, right off the bat.
 
Yes, if the stock market goes down, and interest rates rise, causing bonds to take a hit, having all of their money invested right from the start will cause Sam and Ginny to take a bigger hit. On the other hand, if they use the dollar-cost averaging method, and the stock market rises, while they are slowly tip-toeing that money into their portfolio, they could miss out.
 
Although dollar-cost averaging is a useful technique that can provide some protection to investors who have no downside risk management, as seen from the exercise we just discussed, it is not always the most appropriate strategy. In some circumstances, with the appropriate mix of asset classes and strategies that protect the downside, it is unnecessary.
 
I can’t tell Sam and Ginny what stock and bond prices are going to do in the short-term. No one can. This is why they need to have a healthy investment mix that fits their risk profile and their financial goals. The appropriate asset allocation, coupled with downside risk management, will provide them the short-term protection to quell their fears, while still capturing long-term returns. Problem solved!
 
Be vigilant and stay alert, because you deserve more.