I’ve got a lump sum of money, how and where should I invest?
Every time I’m asked a question like this, I go back to the five steps of The Money Plan. Those are the foundations, the fundamentals, of your finances.
Step 1: what’s your outcome, your goal, with the money? We’ve got to have a purpose before we can do anything with it.
Ask yourself: what is important to you about the money? For some people it might be retirement savings, for others it might be paying down the mortgage as quickly as possible to feel secure.
If your foundations are covered, you’ve got no unsecured debt and you have an emergency reserve between 3-12 months of your expenditure, and you’ve got this money for long-term investing, let’s look at what you can do with it.
How to split it
I suggest you take this money that you’re looking to invest and split it 40/40/20:
- 40% into long-term investments
- 40% overpaying the mortgage
- 20% you should pay it back to yourself, so you can enjoy it
You should be looking for long-term success – quick fixes don’t work. We can deprive ourselves of things for so long, but life is about enjoyment! Whether it’s £100 you’re investing or £100,000, that’s why we pay that 20% back to ourselves, to have some fun.
What if you don’t have a mortgage, what should you do with that 40%? Well, ask yourself where you are in your plan.
Are you playing catch up, have you left it later in life to plan for your retirement? If so, you might need to put most of the 40% you would be paying on your mortgage into your retirement funding, so around 80% goes to your future and 20% for yourself.
If your retirement savings plan looks good and you’ve paid off your mortgage – first of all, pat yourself on the back! And then you might think, ‘I’m doing well, so I’ll put 20% more towards retirement and 20% more towards myself.’ That would give you a 60/40 split.
This is a decision you need to make. If you’ve gone through the first four steps of The Money Plan and you’re now looking to invest, then you’re educated enough to think about these things. Once you’ve decided, let’s look at what to do next.
Where to invest
Speaking very, very generally, the first investment platform to look at is your pension fund. Even before your ISA, that’s where you should probably start allocating your money.
The primary driver behind that is that you’re getting tax relief on the money now (if you put £100 into your pension, £125 gets invested); and then it grows tax-deferred as well. And then, when you take money out from age 55 onwards, you can take 25% of it out as a tax-free lump sum, and draw down the rest as an income, which is taxable. In addition to this, it’s outside of your estate for inheritance tax.
That’s why a pension is the first home for your money, the first wrapper you should be using.
Now as I said, that’s a broad generalisation and for some people it may not be appropriate – for example, you might be reaching your lifetime allowance, or your annual limit (we can only pension up to 100% of our earned income each year). So if a pension isn’t appropriate, you should look at a stocks and shares ISA.
In addition, if you have a lot of money already saved up in your personal pension, which you won’t be able to access until you’re at least 55 years old, and you’re thinking you’d like to take some trips before then, or save up for education fees, or you have something else in mind for your money before that age, then an ISA would be more appropriate.
The stock market
If you’ve got no investment experience, what should you be looking at to get started?
Professionals would call this your investment philosophy – how to decide how to invest your money for the future. What fund or funds should you pick?
At the top level, there are two ways you can invest:
- Actively managed: this means you engage a professional to buy and sell shares or bonds on your behalf. For that, you pay a premium, a higher cost to invest.
- Passively managed, or indexed investing: this is where you buy the market as a whole, using a fund, and allow the market – or capitalism – to provide you with returns.
Which is better? Well, there’s been possibly thousands of research studies done on whether active management provides additional benefits for the cost that you pay. And I’ve previously made a video on a huge bet that Warren Buffett made with any active fund manager in the world that they couldn’t outperform the market, which he won comfortably.
For me, the research shows that the active managers are not providing extra benefit for the cost that you’re paying. The potential extra benefit is a variable, but the cost is a certainty.
I would say: always, always, always index or buy passive funds.
So how can you best do that?
I had this question about four years ago and I went into the market to try and find a decent provider of passively managed funds. Not just one offering consumers individual funds to buy, but a complete and finished solution, a portfolio of funds that was simple to invest in.
I couldn’t find one… so I made one myself. I created Lexo.co.uk, an online investment platform that lets you see the wrappers available and then decide which portfolio you want. You’re not faced with a decision of buying individual funds, you’re buying a solution.
The only decision you need to make is: how much risk can you stand with your money?
Risk and reward
You’ll see from the portfolios on Lexo that the more risk you take, the higher the potential long-term return will be. This has been proven now for somewhere around a century – the more risk we take with our investment, the better the potential returns.
When you’re investing, time is your friend. The more time we have to invest, the higher the probability of our success is going to be; you can ride out ups and downs in the marketplace.
The market right now is doing fantastically well, it’s at an all-time high, but we don’t know what’s going to happen next. It might continue rising. We don’t know. It might fall. We don’t know.
As long as you have at least five, and preferably seven, years to invest, then you should choose a portfolio with a downside that you’re comfortable with, and sit tight. So how do you determine your risk factor?
Start by asking yourself the question. If you have £100 to invest, and it fell in value to £95, how would you feel? What about £85? £60? Lower?
This is very simplistic, and it’s easy to talk about it theoretically. Putting your money on the line, and the size of the money, is different. In the above examples, what if you had £100,000 to invest instead of £100, and it fell to £75,000? Are you still comfortable with that kind of hit?
One thing I do with clients is to ask them about what they feel they’re comfortable with, and then I use charts of how the markets have historically performed to bring some of the numbers to life. Then when they think they’ve found their risk comfort level, I reset the chart to 1 November 2007 – just before Northern Rock went wrong and the financial crash hit, near the peak of the market.
We look at that chart, and we see the amount the clients are looking to invest go down in value. I tell them that at the bottom end of that market, the most extreme point, your portfolio would now be valued at X. I ask, How do you feel? What do you think about the investment? What do you think about me, do you still trust me?! Because at that point, you’ve theoretically lost money.
At some point, your portfolio WILL fall in value. The only question is by how much.
As a very general rule looking at the overall stock market, it typically falls somewhere around 50% in value when it corrects. If you’re investing in a 100% stock market portfolio with your £100,000, you should consider that it could drop in value to £50,000 before it recovers; if you had a 50% market exposure with the other 50% in short-term bonds, your portfolio would fall around 25%, or £25,000.
This is what a professional does: mix the stock market portion of your portfolio, which is where you get your returns from, with lower-risk, fixed-interest funds, your diluter, which reduces the overall level of risk for your portfolio because they are not as volatile.
I don’t believe the majority of the public are sophisticated enough to understand how to properly mix those funds together. Some people reading this might have studied hard and be good at it, but for most people, you’ve got more fun things to do in life!
So with Lexo, what I did was provide the solution: 10 portfolios going from 0% stock market exposure, to 10%, 20% and so on all the way up to 100% stock market exposure.
You can see in the results I show that the 100% exposure portfolio fell around 50% in its worst period of time, which is typically what will happen in a correction as I mentioned; and the falls reduced as you go down to 0% stock market exposure.
But over the long-term, the 100% market exposure portfolio has done particularly well – because the higher the risk, the greater potential return. It’s worth noting too that the worst one-year performance out of any portfolio over several years was also by the 100% exposure portfolio. It’s volatile. That’s why it’s about deciding how much risk can you stomach.
Try using the examples above, but use pounds and not percentages to make it more real. How comfortable are you when it’s your money?
On Lexo, there’s a very simplified risk-assessment questionnaire, you answer the questions and then the system will highlight three portfolios that could be suitable for you. I’ll be adding a risk profiling questionnaire to this site very soon, it’s the one I use with my clients. It’s a very comprehensive and sophisticated psychometric questionnaire on risk profiling, it’s very good. There’s a small fee to download it because it costs us money too, but it’s well worth it. I’ve been using it with my clients for 15 years.
Should you invest or wait?
With the market at an all-time high and with the potential to fall, should you be worried and wait if you’re looking to invest?
A good question to ask yourself is, what are you going to do with your money otherwise? If it’s just going to sit in an account gaining 1%, while inflation stays above 2%, then it’s losing its buying power. The long-term return of the market is greater than inflation and greater than you’ll get on deposit, so you’re better off putting it into the market.
The market may be high, but there’s a golden rule: you can’t time the market. Timing the market is trying to get your money in when it’s on the way up and get it out before it falls. We don’t know where the up is, or where the down is – if you did, you would earn billions!
I come back again to the Warren Buffett bet. The market is high, but companies make profits and grow in value, the market will always grow over time. The thing is, the market has a schizophrenic personality; sometimes it’s high, sometimes it’s low, and it goes up and down, up and down. Just because it’s high now doesn’t mean it will fall next week.
These ups and downs are why I insist on you having at least five years, and preferably at least seven, if you’re investing in the market. That’s historically been long enough to ride out the waves and enjoy the overall growth.
After Northern Rock, the markets fell for around two years. Eighteen months into that, would you have wanted to put your money into the market and predict it was going to rise? Why would anybody have felt positive about the future?
Similarly, people now might say that the market’s been going up for so long it’s going to start correcting… but equally, they might be wrong.
I’ll emphasise again: don’t try and time the market. Time is your friend with investing, make sure you have plenty of it. It’s the time in the market that counts, not timing the market.
If you’re really, really concerned, then you could drip feed your money into the market over a period of time, say six to 18 months. That simply means that you break your £100,000 into chunks and buy into the market with an equal amount each month, e.g. £10,000 per month for 10 months.
This way you’re buying up and down. You might be disadvantaged if the market continues to rise and then falls after 10 months when you’ve finished, or you might be advantaged if the market crashes in month 1 and then recovers.
There are three things to take away if you’re ready to invest:
- Time is your friend: you should be investing for five, six or seven years as a minimum
- Choose a portfolio that gives you as much equity exposure as you’re comfortable sticking with
- Invest, and forget – just keep an eye on what’s happening once a year or so
Once you’ve invested, you should absolutely not obsess over what the markets are doing. If you’ve bought the right portfolio, you’d be best off not reading any financial headlines at all. With an index fund you’re buying the market, and the market will do what it needs to do regardless of the headlines. Bad news sells, and that then you’ll be getting information from many different sides, impacting on your thinking and emotions.
Warren Buffett says that when he invests in a company, he looks for companies that if the stock market closed and he could not sell, he wouldn’t mind; he’d still want to be holding in 10 years’ time. That should tell you everything you need to know.