How Should I Invest an Inheritance?

Many individuals would simply spend the money from an inheritance and have little to show from their relative’s kind gift in a few years.  The wise individual would instead choose to invest the money and use it for income rather than simply spending the principle.  By doing this your relative’s legacy can live on and provide additional income for your whole life; perhaps even that of your children and grandchildren.

The issues you face with an inheritance are similar to that of an investor who has saved throughout her life and now if looking to generate income from the funds.  The goals once a large amount of savings is obtained are to 1) protect the nest egg from loss, 2) gain some income from the funds and 3)grow the value of the funds to keep up with inflation and increase future earnings.  Note that if the income is not needed at this point the savings can be allowed to continue to grow, resulting in even more income later, but at some point this becomes a pointless exercise.

The first thing to do is pay off any credit card debt or other high interest loans such as car and home equity loans.  You will never be able to make enough from investments to offset the usurious rates credit card companies charge.  You may also think about paying off your house even though the rates there are not so bad.  There is just a good feeling in having a paid-for house, and the money that was going to wards payments could then be directed towards investing.  Once these things are taken care of the rest of the funds may be used to generate income and grow through investment.

As a rule-of-thumb about 8% of the value of an investment account can be withdrawn each year without affecting the principle.  This is because the account can be expected to grow by about 8% over inflation over long periods of time, so 8% can be withdrawn while still generating enough return to overcome inflation.  For a $500,000 account income of about $40,000 per year can be generated.  This is ample income to live comfortably from if one has a paid-for house and car.  If one is still working, this could be a substantial boost in income, and if half or more could be directed back into new investments one could build up quite a retirement savings over a period of years.

In times past one could make a reasonable amount of income by investing in high yielding stocks such as utilities and bonds.  Dividend and interest rates are currently at record lows, however, so purchase of these types of securities would not be advisable (because when rates go back up, the price of these assets will fall accordingly).  In the current climate it is instead necessary to generate income primarily through capital gains and sell some shares each year to generate income.  This could be accomplished by buying a basket of growth stocks.  This will result in brokerage commissions being generated, but this is offset somewhat by the lower capital gains tax rates.

With $500,000 between 20 and 50 different stocks should be selected, depending on individual risk tolerance.  The mix should include the large, solid growth companies (those that are very sound financially but still have some room to grow) and a few stocks that are younger and growing more rapidly but perhaps less predictably. As is advised in other posts on investing large amounts of money, the purchase of these shares should be spread out over a period of about a year with perhaps 25% of the money invested each three months.  One could look for days when the market falls significantly to make purchases.

If stock picking is not a skill you possess or wish to learn, spreading the money over five mutual funds that invest in different market segments (for example, large caps, mid caps, small caps, foreign stocks, and REITs) would also be a suitable choice.  Here the money should be divided equally among the groups and the funds rebalanced each year to maintain the distribution.   Once again it would be wise to invest the money over a year period in 25% increments.  This helps improve the average price paid and also aids psychologically since one is less apt to feel apprehensive should the share price drop after the initial purchase is made.

Finally, capital gains are not as predictable as dividends; therefore, withdrawing 8% per year may not be the best strategy.  While returns of 10-15% can be expected over the long-term, yearly returns may range between -30% and positive 50% with little predictability.  To deal with this issue one strategy is to start with enough money in cash to provide for needs for the next 5-10 years.  On years when the value of the account increases by more that 15%, funds are withdrawn until 10 years-worth of income is available in cash.  On years when the return is less, the money is left to grow unless the cash remaining is less than that needed for 5 years, in which case funds are withdrawn as needed to maintain a five-year cash reserve.  In this way shares are sold after good years and allowed to recover in poor years.

To ask a question, email or leave the question in a comment for this blog.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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