How to invest a lump sum
A surprise windfall, whether it's a work bonus, an inheritance or even a divorce settlement, can provide a welcome boost to your finances. But it also demands some tricky decision-making.
You might have immediate plans for the money - an exotic holiday or pressing home improvements, for example – but if you want to secure your finances for the future, a lump sum provides a great opportunity to jump-start an investment plan.
In the final part of our first-time investing series, we focus on three case studies and offer expert recommendations and investment ideas to help you make the most of your cash windfall.
THE YOUNG PROFESSIONAL
Our first investor, a 29-year-old graphic designer, has worked hard this year and been rewarded with an unexpected £1,000 bonus at work.
His finances are in pretty good shape: he has a healthy savings balance and a rainy-day fund for emergencies. He views the unexpected windfall as 'play money' and wants to learn about the stockmarket by investing in stocks and shares, while hopefully earning a decent return.
He has a bullish attitude towards risk and is prepared to take chances with his money.
What he needs to consider...
The money is not earmarked for a future purpose, which means he can afford to speculate. In a worst-case scenario, he'll lose some of his £1,000 bonus, but a few clever decisions could see its value double or even triple over the very long term, even if values fall over the short term (as most have over the past three years).
His willingness to embrace a degree of risk and his desire to learn about investing suggest that putting his money into a traditional unit trust is unlikely to be the best option because a fund manager will make all the investment decisions for him.
Investing in equities provides the best opportunity to achieve bumper double-digit returns on his money, and the most obvious option is to buy individual shares in companies. This would help him learn what to look for on the stockmarket, introduce him to reading company reports, and even enable him to attend annual general meetings to quiz executives.
However, his relatively small investment sum makes such a move too much of a gamble, even with his fairly high tolerance for risk – he would need a substantially bigger sum to spread risk across a large enough number of stocks.
A better option might be an exchange traded fund (ETF), which tracks the performance of a particular index or sector. Listed and traded on stock exchanges, ETFs can provide access to different markets, countries and stock-specific sectors.
Fund: The iShares FTSE 100 tracker
Fund manager: BlackRock Advisors
Amount to invest: £1,000
Value of £100 invested three years ago: £96.53
Alternative investment: The Edinburgh UK Tracker Trust from Aberdeen Asset Management, a UK growth focused trust with very low management fees
Dennis Hall says: "Buying individual shares could be very risky for this investor, as he doesn't have enough money to get a good spread.
"The beauty of ETFs, however, is that you can follow virtually any index in any market you like with ease. The UK market is racy enough for most first-time investors, but if he hankers after a taste of Brazil, China or emerging markets, then there's an ETF for it."
THE MARRIED COUPLE
Our next investors are a married couple who recently received a £10,000 inheritance from a distant relative. They have three young children under the age of eight and are comfortably managing their family's financial commitments.
The couple wants to set aside the windfall for their children's future by investing for growth, with a relatively low degree of risk. Their aim is to build a fund that will set their children up in life – covering costs such as university and helping with house deposits.
What they need to consider...
At the moment stockmarkets are volatile and there is nervous talk about a double-dip recession. These issues should weigh heavily on the minds of our couple when deciding where to invest.
While it's a nice bonus, the £10,000 inheritance received is not a life-changing sum of money and certainly nowhere near enough now to fund the aspirations they have for their children.
Although they have the best part of 12 years before they'll need to call on their money, no one knows for sure how the next decade will pan out and which asset classes will deliver most favourably.
A sensible option would be to embrace the increasingly popular multi-asset style of investing, which gives investors exposure to a broad range of asset classes, including equities, fixed income and property. While this diversified approach means they are unlikely to enjoy the full benefit of an equity bull run, they won't lose their shirts if stockmarkets tumble.
If they are prepared to take a bit more risk now, an actively managed growth fund giving them access to a global spread of equities and fixed interest, such as Jupiter Merlin Growth, might be worth a look.
Whatever route they take, the couple will need to adopt the same approach to investing as those approaching retirement. Some time before the money is needed, perhaps two years before the first child goes to university, they should move into more cautious managed funds.
7IM AAP Balanced Portfolio
Manager: 7IM asset allocation team
Amount to invest: £10,000
Value of £100 invested since launch (27/3/2008): £109.95
Dennis Hall says: "I would recommend a multi-asset class fund. To keep costs low, I would choose a fund that uses passive assets such as ETFs in a balanced managed fund approach.
"I like the 7IM AAP Balanced Portfolio. It has extremely low charges compared with other multi-asset funds, and it spreads risk because not all its eggs are in one basket. The fund invests in shares, property, commodities and fixed interest."
THE RECENT DIVORCEE
Following her marriage breakdown, our 50-year-old third investor has been through a tough time, financially and emotionally. But with the divorce finally behind her, she is looking to invest £20,000 of her settlement.
Her intention is to grow the money and beat the lousy savings returns on offer with her high street bank, but she needs to supplement her retirement income and doesn't want to take an unnecessary risk with the money.
What she needs to consider...
Our third investor faces the difficult task of weighing up her desire to earn a decent return against the fact that her ability to recover from major losses will be limited. With just 10 years to go before she plans to retire, she has relatively little time to make her money grow.
The only way to achieve bumper returns in a short time is to take a substantial risk. However, she is not prepared to take chances with her cash and has already earmarked it as a useful way to meet her longer-term needs by boosting her retirement income.
To achieve her goals, some equity exposure is essential to build up the retirement pot. But investing in fixed income assets is also required to deliver an income when she eventually needs it. The most viable solution to her needs would be a mix of funds that provide access to both global growth and income.
The funds we recommend are well placed to take advantage of future growth and would allow her to benefit from the accumulation units offered by income-driven funds. These automatically re-invest dividends back into the same fund to enable the value units to increase.
Investec Monthly High Income
Managers: Kieran Roane and Theodore Stamos
Amount to invest: £5,000
Value of £100 invested three years ago: £122.29
Invesco Perpetual Income fund
Manager: Neil Woodford
Amount to invest: £5,000
Value of £100 invested three years ago: £97.18
M&G Strategic Corporate Bond
Manager: Richard Woolnough
Amount to invest: £5,000
Value of £100 invested three years ago: £143.90
M&G Global Leaders to provide 25% exposure to Global Growth - switch to an income fund later
Manager: Aled Smith
Amount to invest: £5,000
Value of £100 invested three years ago: £93.60
Dennis Hall says: "Investor Three should have equity exposure alongside some fixed interest, but the equities should have a bias towards income to benefit from dividend yields."
Our fund advice comes from investment guru Dennis Hall, founder of Yellowtail Financial Planning. The former Royal Marine has won a number of industry awards and appeared on radio and TV, principally the BBC and Sky.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
An unexpected one-off financial gain in cash or shares, generally when mutual building societies convert to stock market-quoted banks. Also windfall tax, a one-off tax imposed by government. The UK government applied such a measure in the Budget of July 1997 on the profits of privatised utilities companies.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.
An Exchange traded fund is a security that tracks an index or commodity but is traded in the same way as a share on an exchange. ETFs allow investors the convenience of purchasing a broad basket of securities in a single transaction, essentially offering the convenience of a stock with the diversification offered by a pooled fund, such as a unit trust. Investors buying an ETF are basically investing in the performance of an underlying bundle of securities, usually those representing a particular index or sector. They have no front or back-end fees but, because they trade as shares, each ETF purchase will be charged a brokerage commission.