Tailoring a Portfolio

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This post and the next two are devoted to constructing an investment portfolio.  This first post takes up broad divisions – the mix of cash, stocks, and bonds — what professional investors refer to as asset allocation. The next post will focus on the portfolio’s bond assets and the third will discuss its stock assets.

Typically, a broker’s portfolio report begins with the overall amounts you have in cash, in stocks, and in bonds.  The report then gets into intricate detail, listing all the bonds, who issued each, the original “coupon” rate as a percent of the bond’s face amount, and its maturity date.  (See this earlier post for an explanation of these terms.) The broker’s report will probably also show how much you paid for each bond, its current value, and perhaps the interest payments you earned from it since the last report.  A comparable listing of the stocks in your portfolio will show the name of the issuing corporation, the number of shares you own, what you paid for them, their current value, and possibly dividend payments since the last report.

While these reports are useful to brokers, bankers, and accountants, portfolio managers look at holdings more broadly to consider how they can achieve two key objectives for you:

  1. Good diversification: An effort to avoid having too many eggs, meaning dollars, in one basket, that is too many of one security or type of security. If you could always pick the best, you would not need to diversify.  But perfect foresight is impossible, so spreading your wealth among different types of stocks and bonds will protect the portfolio from setbacks by ensuring that its different parts respond to events in different ways.  Such diversification of exposure allows your portfolio to secure the most gain with the least amount of risk.
  2. Serving the specific goals of the investor: Are your portfolio’s assets meant to provide retirement income?  To buy a vacation home? Or to pay for a newborn child’s college education? These and other long-term objectives will determine what sorts of stocks and bonds your portfolio should hold and how it should mix the types of securities to get the greatest prospective return for the least risk.

So think of the stocks and bonds in the portfolio not necessarily as individual holdings but rather as the best possible representatives of the sort of security that serves these basic aims.

There is no perfect mix.  Your right combination will depend heavily on your particular circumstances and preferences — what many in the investment business term your life-cycle/life-style situation.  Some people cope better than others with risk and occasional loses.  Those more suited to a riskier life style feel comfortable reaching for gains in a more volatile portfolio.  The mix you choose should also reflect where you are in your life cycle.  Young people investing for retirement, for example, will not need the money for years, so they can take more risk to earn greater returns than can older investors who are approaching the end of their working lives and have less opportunity to make up for an investment loss or time to wait for a market rebound after a setback.

Portfolios need to reflect such differences.  Young people, who will not need the money for years, particularly risk-takers, may want few or no bonds in their portfolios. They may want to concentrate on stocks, particularly smaller, less established stocks, because these, though more volatile than other investments, tend over time to gain more than bonds and more conservative stocks.  To be sure, stocks generally and particularly those of less established companies may suffer severe occasional reverses.  But as a group they eventually always come back.  An investor with a long time horizon can count on that recovery.  Someone older, with less opportunity to wait out a temporary setback, may want more bonds and stable, dividend-paying stocks. Retirees, who are already living off investment income, may also prefer bonds and dividend-paying stocks because they also tend to generate more immediate income than less established stocks.

There are many ways to combine stocks and bonds to meet portfolio goals. The aim is to learn their characteristics and create a good investment fit for your critical needs.  The next post will explain the role of bonds and the one following will do the same with stocks.

 

What About Investment Clubs?

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Several readers have had questions about investment clubs.  They are coming from both beginning investors, who hope they will learn by joining one, and more experienced investors, hoping that a club will allow them to show their stuff.  The answer to both questions is, “Yes” — beginning investors can learn a lot in a club and the more sophisticated can increase the breadth of their investment action.  But not all clubs are created equal.  Some function better than others, both for learning and for investment success.  Here’s a guide for choosing a club or even starting one.

Investment clubs are surely the most enjoyable way to invest your money, and they can offer an investment education as well.  Most are private groups of 15 or at most 20 members, who pool their resources to invest, usually buying stocks but sometimes also bonds and more exotic investment instruments.  (Subsequent posts will focus on different investment vehicles, explaining what they are and how to buy and sell them.  A recent post on stock basics began that process.)

Organization 

Clubs typically organize themselves around a community, a church, a synagogue, an adult education center, or even just a neighborhood group.  They require monthly payments (which can range upwards from $20) into a common fund.  They meet regularly, usually twice a month, to discuss investing and consider sell and buy decisions.

Most clubs appoint or elect officers to establish an administrative structure along these lines:

  • A president who sets meeting dates, plans activities, and runs discussions.
  • A vice president to fill in for an absent president.
  • A treasurer who controls the club’s brokerage and banking accounts and places all buy and sell orders
  • A secretary to remind members of meetings and keep complete minutes. This last function is critical.  Investment discussions can become complicated.  Because not all investments work out as well as others, it is essential to know which members said what and when — not to assign blame, which would surely destroy the club, but to learn from past mistakes.
  • A “director of research” or “education officer” who distributes research material among members, perhaps invites guest speakers, and arranges field trips to broker presentations, for instance, or even the headquarters of a firm in which the club has a stake or is considering one.

If there are no clubs in your area, you can establish one.  Make sure the members are compatible.  Investment discussions inevitably involve disputes, and it is crucial that members know how to handle these in a productive manner.  It is also important that at least some members have investment experience beyond sometimes reading The Wall Street Journal or The Financial Times.  Actual experience in an investment firm or a broker would be ideal.

Best Practice

During the 2008-09 financial crisis, many clubs lost a lot of money and disbanded, experiences that left behind much disillusionment. But there is nothing inherent to clubs that makes them more vulnerable than any other investment arrangement.  (Many professional investors also lost a lot of money during the crisis.)  The best approach is not to dismiss the idea of clubs but rather to ensure that the ones you join maintain clear guidelines on how they invest and how they control risk.  These guidelines can limit losses even in the worst of times and even blunt, if not completely eliminate, conflict among club members.  Guidelines might include:

  • Procedures to receive new members and for members to withdraw their funds.
  • To determine when the club will reinvest dividends and interest payments and when it will distribute them among the members.
  • Which newsletters and research materials the club will use and at what interval it will reconsider these subscriptions.
  • The establishment of risk guidelines up front that:
    • Insure adequate diversification among different sorts of assets (of which more in subsequent posts) the club should determine the maximum proportion of the club’s assets that it can hold in a single stock or bond.  As a rule of thumb, the upper limit should seldom exceed 5 percent.
    • Determine exactly what sorts of investment vehicles it will and will not use — stocks, bonds, foreign securities, real estate, and the like.  (More on each of these in coming posts.)
    • With an eye to controlling losses, how much volatility or loss it would tolerate in any holding before reconsidering it.  (Some clubs set an automatic sell, called a “stop-loss order,” when a holding reaches this point.)

Guidance on best investment practice for clubs is available from umbrella organizations.  The largest is Better Investing, www.betterinvesting.org. It claims five million investors.  For a small fee per club member, your club can join Better Investing.  It will offer training and educational material, considerable investment research, discounts on subscriptions, and the ability to buy general liability insurance, which could become desirable as the assets involved grow.  The Securities and Exchange Commission (SEC) also has information on investment clubs at www.sec.gov/reportspubs/investor-publications/investorpubsinvclubhtm.html.

You might also seek more general and in-depth investment insight at ProsperAmerica.  You will find its website at www.prosperamerica.org

Stock Basics

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Stocks remain a popular investment vehicle and with good reason – they amount to a wager on the economy’s future.  Equities, as stocks are often called, rise and fall according to all the particulars that affect corporate profits — but basically they rise when the economy has promise and fall during recessions or when investors otherwise doubt the economy’s prospects.  Because stock prices can at times move violently, investors, unless they are lucky timing their purchases and sales, will realize their best payoff over the longer term.  The longer you can wait for the returns, the more stocks you will have in your investment portfolio.  (More on this in a later post.)  

What Are Stocks?

Stocks are a partial ownership in all that the issuing firm owns and earns.  Companies issue stock to raise money, usually for expansion.  This money is called equity capital.  

There is no limit to how many shares a company can issue. Managements that prefer to limit ownership in just a few hands issue relatively few shares.  Companies with expansion plans that require a lot of financial capital often issue thousands of shares.  There are benefits and disadvantages to either approach.  Using equity (stocks) instead of borrowed capital (money) can make the company more financially stable.  In hard times, the firm has to pay lenders even if it makes no money, but shareholders can claim only a share of the profits.  The disadvantage of issuing more shares is that they dilute the value of existing shareholders.

The most common sort of stock is called, not surprisingly, common stock.  These entitle their owners to any distribution of company profits, called dividends.  Owners are also entitled to elect board members and vote on other basic matters of ownership.  Each share gets one vote, not each shareholder.  The largest shareholders generally have control of the company’s decisions.  Companies sometimes issue preferred shares.  These tend to command more generous dividends than common shares and usually stand before common shares should the company suffer bankruptcy, but they typically lack voting rights.

Making Money in Stocks

Stocks offer two ways to make money:

  1. Dividends are periodic cash payments (almost always quarterly) that management pays shareholders out of the firm’s profits, what financial people usually refer to as earnings.  Dividends are entirely at the discretion of the corporation’s board of directors.  Usually, the board makes its decision based on how much the company has earned and what other uses it has for the money — say investing in new facilities.  Companies that are growing fast and need to invest to keep up with their expanding business pay low or no dividends.  Slower growing firms with less need for the money pay higher dividends.
  2. A more important way of making money in stocks is price appreciation.  This is determined solely in the market where investors trade available shares of stock. Neither management nor the board of directors has any direct control over this activity.  If the company is doing well, earnings are growing, and there is a promise of further growth, people will want to own a piece of that action and their buying bids up the price of the stock.  This works in reverse if the firm faces trouble.  Appreciation can also reflect dividends.  Higher dividends will often attract buyers whose demand prompts price appreciation.

The Roots of Price Fluctuations

Stock prices fluctuate as investors alter their expectations of future profits.  Financial theory holds that the fair price of a stock is only a reflection of the flow of future dividends and the earnings that might support future dividends.  That future flow is discounted, because dollars you have today can be invested and earn money, whereas future dollars are inevitably uncertain and cannot earn until they are paid.  A well-regarded algorithm, called the “dividend discount equation” calculates a fair price for a stock by so discounting prospective earnings and dividends.  Anything that improves a company’s profits next to the expectations previously built into its price will to raise that stock’s price.  Anything that makes the future look more problematic tends to drive its price down.

A number of factors can influence these calculations, some general, some specific to the industries in which the company operates, some specific to the company.  A complete list would fill several volumes, but here are seven main issues that move stock prices:

(1) The Economy

Because profits generally follow overall economic activity, an improved economic picture promotes a general rise in stock prices, called a rally or a bull market.  Economic clouds prompt stock price declines, called a correction or a bear market. Because no one can know the future, stock investors continually assess economic trends and revise their opinions accordingly. The flow of news is continual.  The list of indicators, statistical or otherwise, is too long for this space and absorbs the attention of thousands who work in the industry, making it very hard for an individual to get ahead of the market’s regular reassessments.

The movement of interest rates also has an effect.  Because lower interest rates make borrowing cheaper and so more likely that consumers will spend and business expand, they usually signal an economic pickup that tends to lift stock prices.  An interest rate increase, because it has the opposite economic effect, tends to depress stock prices.  Interest rates also feed directly into stock valuations. Because higher interest rates offer better ways for your dollars to earn, they prompt investors to discount future dollars more severely, depressing stock prices.  An interest rate decline has an opposite effect.

(2) The Industry

Even more than changing perceptions of the general economy, industry-specific considerations move stock prices.  Are oil prices rising?  That’s good for those who produce oil and who service the oilrigs.  It’s bad for those who use oil — airlines and truckers, for instance.  A technological breakthrough may benefit some at the expense of others.  A bumper wheat crop abroad will hurt American wheat farmers by depressing the prices their harvest can command, but it could help food processing firms who buy grain. These few examples only hint at the constant flow of industry information that just as constantly changes market opinion and moves stock prices.

(3) Legislation and Regulation

Here, too, the flow of news is endless.  If Washington, for instance, were to support a major infrastructure-rebuilding program, prospects for construction firms would improve and their stock prices would rise accordingly.  A decision to step up defense spending would definitely boost prospects among defense contractors and so the prices of their stocks.  The Affordable Care Act (ACA) improved prospects for health care insurers (at least initially) by driving millions of new customers their way.  But such news can cut the opposite way.  The adverse effect of such spending on Washington’s finances might negatively impact stock prices by threatening to push up interest rates or taxes or both.

Regulation, at the national, state, or city level, can have its own effects.  Environmental rules will enhance the prospects of some firms at the expense of others, say solar over coal.  Stricter financial regulations after the crash of 2008-09 had a powerful effect on financial firms, especially smaller ones.  Safety regulations raise costs for some firms and industries but create opportunities to those that sell products to help other firms comply with those regulations.  Here, too, the flow of information constantly changes investor assessments of the future and thus stock prices.

(4) News About Staff

If a company hires someone with widely recognized ability, investors may expect an improvement in the company’s fortunes and buy its stock, pushing up its price.  The loss of a key executive can raise questions about the future and so depress the company’s stock price.  A large number of departures, even of not-so-famous, middle-level employees, can raise questions about the firm’s ability to manage and so push down its stock price.

Scandals also move prices.  A staff member who runs afoul of the law can depress the company’s stock price by increasing investor worries over fines or other legal actions. This sort of news tends to break suddenly, creating violent swings in stock prices.  Bad news for one firm, of course, might also lift the prospects of its competitors and so of their stock prices.

(5) The Firm’s Product Line

Any change in product line, positive or negative, will move the company’s stock in a sympathetic direction.  Drug companies are particularly vulnerable.  Bringing new drugs to market is a very lengthy process, and failure could cost these firms dearly.  Lawsuits involving pharmaceutical companies are more expensive than in other industries. But a successful new drug, sometimes referred to as a “blockbuster drug,” can lift profit prospects dramatically and the company’s stock price with it. Drugs are just one example.

(6) Natural and Political Events

Stock prices also respond to geopolitics and natural events. Revolution, war, elections, and natural disasters anywhere can disrupt business and affect stock prices.  Tariffs, much in the news today, can help the firms protected by them and hurt those who have to face them.  An earthquake could wipe out an industrial operation.  Even if insured, the firm’s stock price would suffer because the company would have lost its ability to engage in otherwise lucrative businesses.  If the disaster is large enough, that company’s insurers might find themselves facing huge payouts that could bring down their stock prices.  For investors, reassessment is always continual as is the movement of stock prices.

(7) Buybacks, Mergers, and Acquisitions

Management may from time to time decide to use retained earnings to buy back their own stock on the market.  Typically, it is done in lieu of raising dividends.  Such additional demand for the stock will tend to raise its price.  But when the buyback program ends, the sudden drop in demand for the stock can depress its price.

Mergers and acquisitions (M&A) happen for all sorts of reasons.  They usually generate a lot of drama and so a great deal of media attention. Sometimes the buyer sees what the financial community calls “synergies,” meaning that the business of the acquired firm has many similarities to that of the acquirer and hence opportunities for efficiencies or market dominance.  Sometimes the merger occurs between two quite different parties that see a way to diversify their respective product lines.  Some acquisitions are hostile— meaning that the firm being bought resists the transaction.   Others are amicable— meaning that both parties like the idea of merging.  The effect on stock prices varies depending on the structure of the deal, which can become very complicated.  Generally, the buyer’s stock suffers and the stock they are buying rises, at least initially.  This often happens in a hostile acquisition, as the buyers will try to blunt opposition by raising the price they offer for the other’s stock.

Getting into the Action

Taking all this into account, you might well ask why any individual investor would risk stock ownership.  Such a hesitation is understandable.  But an investor who will not need the money for a long time and has basic confidence in the firm’s management and its products can feel secure that its stock will rise over the long term.  There are also ways to enlist professional help in making all these continual assessments. More on these options in subsequent posts

First Steps for a New Investor

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For many, investing seems to happen in a foreign place where the inhabitants speak a strange language.  Most don’t know where to begin, and it’s easy to understand why:  They don’t teach this stuff in school.  One thing, however, is clear.  Unless you entered life with a trust fund, investing starts with small savings and the cultivation of the savings habit.  So let’s start at the beginning, with techniques for saving and how to plan your investment scheme.

Developing the Saving Habit

Too many of us procrastinate.  It’s easy to convince yourself that setting aside only a few dollars will make little difference compared to some “urgent” household or personal need. While sometimes these needs can be genuinely important, most are usually an excuse to put off saving and seek immediate gratification instead.  It might help you resist temptation to realize that every dollar you save each week or even each month will start growing beyond what you are depositing, what I call building on itself.  And soon the increased savings will offer their own gratifications.  The effort will also help you strengthen your saving habit, which, in most cases, is more than half the battle.

Here are seven tips to get in the habit of saving:

  1. Put aside all your loose change in a jar at the end of the day.  Better yet, add a dollar or five dollars into the jar each evening.  Such small amounts can quickly become a significant contribution to your savings. And most of the time it’s money that you won’t miss.
  2. Leave your credit cards at home.  Paying with cash will put a cap on how much you spend at a given time.  And if you have to run home to get the card, it might give you time to rethink an unnecessary expenditure.
  3. Contribute to stock purchase plans and reinvest the dividends.  Many companies allow employees to use part of their paychecks to buy the firm’s stock through automatic deductions.  This is money you might otherwise spend.  If you are in such a program, reinvest the dividends instead of taking them in cash.  This is a good rule to follow with any stock you own.
  4. Consider savings as you would any regular expense — like bills from the electric company or mortgage payments.  Set a dollar amount, say 1 percent of your take-home pay, or better yet 5 percent if you can, and “pay” that into your savings account each paycheck.
  5. Use automatic savings plans.  Some employers offer plans that take a designated amount of your paycheck to buy you U.S. government savings bonds (more on these in later posts).  Ask your bank if it can automatically transfer a designated amount each month from your checking to your savings account.
  6. Keep putting money aside even after you have paid off a loan or a mortgage.  Continue to write a check every month for the same amount, or at least a good portion of it, and put it into your savings.  This is money that you have long learned to live without, so you can increase your wealth painlessly.
  7. Occasionally give yourself a reward.  Saving is hard, and its payoff is often years in the future.  So once or twice a year, designate one month’s set aside for a little extra spending. Take the family out to dinner or buy something special for yourself or someone you love. It will give you something to look forward to that is nearer in time than the ultimate use of your savings.

Make a Plan 

Though saving and investment plans vary as much as individual desires and goals, one element should appear in every plan: an emergency fund, a pool of cash for unforeseen events, like sudden medical problems, appliance repairs, or possible unemployment. Ideally, set aside 3 to 6 months income to cover such needs. The money should go into what financial people call a “liquid vehicle,” one that you can access immediately such as a bank savings account or other easily accessible vehicles that I will describe in subsequent posts.  Once in place, this saved money will work for you: by building on itself through bank interest and by protecting you and your loved ones from harm.  Importantly, it will also give you confidence to take the next steps.

Once you have established this basic source of security, and the habit of saving, you can begin focusing on personal wants and needs. There is no right answer here. Much depends on your age, income, family circumstances, and interests. The money should serve your desires as well as your needs.  Some goals are very long term, like a young person saving for retirement.  Others are not quite that far off, like college for a newborn or buying a home, or starting a new business.  Still others may be more immediate, like buying a new car or kitchen.  All are legitimate, but each requires a different investment strategy.

To organize your thinking, create a small chart like the one at the end of this section.  It can link each need to an investment goal.  List your savings goals on the left.  I offer a few examples.  Yours will be different.  Next, fill in the likely cost.  You can research this on the Internet but in the case of housing for example, you may also want to do a bit more research about what it will cost when you are ready to buy.  Next, determine when you expect to need the money.  Count the months to that date and divide the cost by the number of months to see how much you’ll have to put aside each month.

The “months to go” will reflect where you are in your financial life.  A parent starting a college fund for a newborn, will be looking at an 18-year time horizon (216 months) before he or she needs the money.  Other goals will reflect more personal preferences.  If you think your car will last only another year, you’ll have to save for the replacement in only twelve months.  Plans to marry in two years will give you 24 months to accumulate the desired funds.  If planning reveals that your goal requires more savings a month than you can support, you might have to adjust your lifestyle, delay the target date, or even abandon this particular goal.  Harsh as these tradeoffs may seem, they are simply facts of life that no one can ignore.

                                                               Planning Guide                   

Goal Cost Date Months to Go Set Aside Each Month
Car Purchase:
Purchase of Home Entertainment System:
Money for a Good Vacation:
Funds to Buy a New Kitchen:
Purchase of a Home:
Money for a Retirement Nest Egg:  

 

 

Executing the Plan — Time is on Your Side

The further in the future your target date is, the less harsh the tradeoffs.  Remember that everything you save earns interest or dividends that over time will build the fund alongside your monthly savings contributions.  Because you are paid this interest not only on your contributions but also on the interest previously accumulated, what financial people call compounding, the longer you can wait before using the money, the more your savings or investment plan will help you accumulate.  These earnings will defray the burden of the monthly set aside.  Two examples:

One:  You need $20,000 for a car and a year to get the money.  Here, returns from investments will contribute only a small part of the total. In this example, it will require a set aside of about $1,629 a month.  Even if the savings account pays 5 percent, it would earn only about $88 over the course of the year. So most of the money would have to come from your monthly savings contributions.

Two:  With longer-term projects, however, earnings from savings and investments can contribute considerably more.  Say you are one of a newly married couple that wants to buy a $250,000 home in 15 years. To meet your goal entirely from setting money aside, you would have to save $1,389 a month.  But after five years of saving at that rate, your accumulated investment account would amount to $83,333.  At 5 percent interest, it would earn $4,723 a year from then on and more each successive year from the accumulated interest as well as your contributions.  That income alone would effectively substitute for over three months of future savings every year.  After ten years, you would have accumulated $166,666.  At a 5 percent interest return, it would earn $10,784 a year, enough to pay over seven months’ required savings.  These would amount to a major contribution toward your goal of home ownership. This is why time is on your side. The table at the end of this post lays out the accumulations of savings and interest year by year.

With even longer time horizons — say retirement savings — the contribution from investment income becomes even more significant. Over 30 years, in fact, the accumulated earnings from the investments would actually exceed the total of monthly set-asides.  In the example of the home purchase, the annual earnings from accumulated savings already by the fifteenth year would have come close to surpassing the annual savings need originally calculated.

 

                                    Interest Earnings Help Savings Accumulate

Years Yearly Savings Set Aside[1] Earnings on Savings[2] Total Available[3]
1 $16,667 $16,667
2 $16,667 $833 $34,167
3 $16,667 $1,708 $52,542
4 $16,667 $2,627 $71,835
5 $16,667 $3,592 $92,094
6 $16,667 $4,605 $113,365
7 $16,667 $5,668 $135,700
8 $16,667 $6,785 $159,152
9 $16,667 $7,958 $183,776
10 $16,667 $9,189 $209,632
11 $16,667 $10,482 $236,780
12 $16,667 $11,840 $265,285
13 $16,667 $13,264 $295,216
14 $16,667 $14,762 $326,644
15 $16,667 $16,332 $359,643

 

[1]$1,389 a month for 12 months = $16,667.

[2]Five percent on the account amount of the previous year.

[3]Savings set aside plus the earnings on the accumulated savings.

 

So…You’ve Come Into Some Money…

So...You've Come Into Some Money?

Just suppose you receive a windfall: an inheritance, a legal settlement, or the transfer of pension funds when you retire.  Though more money is always better than less, such money flows do impose hard decisions. Many people feel insecure about what to do.  They frequently don’t know what decisions they need to make.  Here are the necessary steps to guide you:

First Steps

First, decide whether the windfall is sufficient to change your lifestyle or simply improve it.

Rule of Thumb: You need investable funds amounting to between 15 to 20 times your annual income in order to quit your job and pursue a life of leisure.

If the windfall and your other savings approach such an amount, you must take two further steps:

  • See an accountant or a tax lawyer to understand the tax implications of the money you have received.
  • Find a reliable financial planner to invest the funds in a diversified conservative portfolio such that it can securely support your new lifestyle. (In later posts I will discuss how to build such a portfolio.)

Two Following Steps

If the windfall does not come up to 15-20 times your yearly income, you will need to make some perhaps difficult personal decisions for yourself and/or your family:

  • Pay off your credit card debt. Interest charges here can be the most onerous short of a loan shark.  The most effective thing you can do with any surplus funds is to discharge these obligations.  Start with the credit cards that charge the highest rates.  (This figure should appear prominently on your card statement.)
  • Identify your critical spending needs. These would be the things you wanted to do before the windfall but couldn’t afford. You may need a new car or a second car. Your home may need repairs you have had to put off.  Perhaps your family or friends need a helping hand.  You, your spouse, or significant other may need a good vacation.  This is a partial list, but it should give the idea. After you’ve made the list, estimate the costs and then put those monies in a safe, relatively liquid account from which you can quickly withdraw them.  (In future posts, I’ll examine such accounts and discuss how to choose one that is best for you.)

Three Additional Decisions

If funds remain in the windfall, you will need to decide three big matters:

  • The Mortgage: If you own your home, you may want to use some of the funds to pay off the mortgage. How much depends on how much you can expect to earn from investing the funds.  If the investments earn less after tax than the interest on the mortgage, then the windfall is well used to pay it off.  If those investments can earn more, then you would do better to invest the funds and maintain the mortgage.  If the difference is close, your desire for security may reasonably sway you to paying it off.

Here’s an example.  Say you have inherited enough so that after “critical expenses” you have $250,000 left.  Say also you have an outstanding mortgage on your house of just that amount and the interest is 5 percent.  The mortgage, aside from payments on principal, costs you $12,500 a year.  If you are taxed at about 30 percent and deduct the interest expense from your tax bill, the after-tax mortgage expense comes to $8,750 a year.  At the time of this writing, an investor can reasonably expect a conservative portfolio to return about 6 percent a year––about $15,000 on the $250,000 windfall.  You will pay 30 percent in taxes ($4,500), giving you an after-tax return of $10,500 a year ($15,000-$4,500).  This significantly exceeds the after-tax annual mortgage expense, so unless owning the house outright is very important to you psychologically, you would do well to leave the mortgage in place and invest the money.  Of course, this is just an example.  Each person or family has specifics that could change the conclusion.

If you are renting or own a place that seems inadequate to your needs, you can legitimately use the money to buy a better place.  How much you dedicate to this–– whether you buy outright or put it down on a mortgage––hinges on the calculation just described.

  • Educating the Kids: A child’s education involves a simpler calculation.  You should have an idea what schooling after high school will cost, and how many years you have to accumulate the funds.  Assuming an annual investment return of 6 percent, you can calculate on any computer or business calculator how much you need to put to work in an investment to accumulate to what you’ll need when your child is ready.  This will tell you how much of the windfall you will need for this purpose.

Again a numerical example might help clarify.  Say you have one child who is five years old when you receive the windfall and that so far you have saved nothing for his or her higher education.  You estimate that by the time your child is ready to attend a state college in some thirteen years, the cost will be $30,000 a year––$120,000 for four years of study.  At 6 percent a year, the calculator will tell you that some $56,000 put to work in investments today will accumulate to what you need in 13 years.  Now you know what portion of the windfall need to go to the college account.  (More specifics on these in a later post.)

  • Retirement Savings: Funding for retirement is the most open-ended question.  Any investment you make instead of paying off the mortgage will contribute to your retirement.  Depending on your age and nearness to retirement, the amounts needed will vary, as will the appropriate kinds of investments.  (A future post will cover this material.)  But generally there is more flexibility here than with the mortgage or school decisions.  Of course, the bigger your retirement pool of assets, the better, so always dedicate as much as you reasonably can to retirement.  You may want to pay for your child’s education, but at the same time you probably don’t want to rely on support from your offspring in your old age.

 

A NOTE TO MY READERS: IF YOU HAVE A FINANCIAL ISSUE YOU’D LIKE ME TO DISCUSS, LET ME KNOW. IF I THINK IT HAS GENERAL APPEAL, I’LL DEVOTE A FUTURE ESSAY TO IT.