So you have a million dollars and you want to make it last rather than blowing it all on stuff. Good plan! But how do you invest all of that new-found wealth so that it will keep providing you with income throughout your lifetime and maybe that of your children and your grandchildren?
Well, the answer depends on how old you are when you got the million dollars and how much other money you have. If you are young and have a job that provides a steady income, you can afford to invest the money in things that will fluctuate more wildly but provide a greater return over time. If you are entering retirement, however, and that $1 M is a payout from your pension plan or 401K and that is all of the money you’ll have to pay for your expenses through retirement, that is an entirely different scenario. I’ll therefore look at a few different situations and the thought process that would go into setting up an investment plan in each case. Since your situation will be particular to you, buying a couple of hours of a financial advisor’s time would be well worth the investment. Just kindly say “thanks but no thanks” if he tries to sell you a bunch of products because there are plenty of good investments in the open markets that will be cheaper and provide a better return.
Case 1: 25 year-old:
Let’s first look at the case of a 25-year old who wins the lottery. This individual, let’s call her Cindy, still has years to earn a paycheck and therefore can put the money away for a long period of time and let it grow. Perhaps she would like to enhance her lifestyle a bit – she did win the lottery after all – but also wants to let her money earn money so she can turn that $1 M into $10 M or even $100 M by the time she stops working. Cindy would want to invest mainly in growth stocks that would allow her to build wealth while minimizing taxes along the way. She could also spend a portion of the earnings from the stocks, allowing her to do things like take nice vacations and improve her home, while reinvesting the majority of her earnings to let her wealth grow.
Things she should do, therefore, are:
1) Pay off any debts she has outstanding. She should pay off credit cards, car loans, and even her mortgage. This reduces her risk substantially and lets her keep her whole income instead of paying it out to others as interest. Rich people make interest, they don’t pay interest.
2) Put $10,000 into a bank account. This is her emergency fund that will allow her to take care of any unexpected expenses like a broken leg or a car repair without needing to dip into her investments. She should keep about half to two-thirds of this money liquid and maybe put one half to one-third in a 3-6 month CD to earn a little more money. If she needed to, she could sell the CD early and just forfeit a little interest.
3) Invest the remainder in stock mutual funds. A good mix would be 25% in large cap growth, 25% in small cap growth, 25% in international stocks, and maybe 25% in a value fund. She could also mix real estate into the mix by purchasing shares of a REIT or a REIT fund, or by purchasing a couple of small rental houses for cash and renting them out if she feels like being a landlord. If desired, Cindy could also buy a set of individual stocks with some of the money. For example, she could take $150k of the money and buy $25,000-$30,000 positions in 5-6 individual stocks in different industries and invest the remainder in mutual funds as specified above. This would give her the chance to significantly increase her return if one of the companies outperformed the markets while still using plenty of diversification.
4) Set a threshold of 8% above which she withdraws some cash, perhaps half of the earnings above 8%. For example, if her portfolio returns 10% one year, she would withdraw 1% and spend it as she wished. If she had a year like 2013 where returns were over 25%, she might withdraw 8% (which would be around $100,000) and maybe do something major like a major home upgrade, moving into a nicer home, or buying a vacation condo. On years when the return was 8% or less, she would let the money reinvest and continue to grow. She could also put money in a cash account on the really good years and then spend it over the next several years for things like vacations and newer cars.
Case 2: 50 year-old:
Our 50 year-old, let call him Matt, has retirement not too far into his future. It is great that he has this million dollars to get things in order and go into retirement in style. Assuming that he won’t retire until 65, he has the chance to double his money a couple of times in the stock market if the economy cooperates and it is not a period like 2000-2009, meaning that he could enter retirement with $4 M. If he works until he is 71, he might even be able to double it three times, leaving him with $8M for retirement. This is a bit aggressive, however, since he really doesn’t have the time to recover from a bad market loss. It happens very rarely, but there are times like 1929 where he may not see high portfolio recover to its previous value for 10-15 years or more. He therefore needs to use some caution in allocating his funds.
Things Matt should do are:
1) Pay off any debts. This is still the number one thing he can do to improve his financial security. Given that retirement isn’t that far away, he should certainly retire his mortgage and direct the money he was paying towards expenses like college tuition so that his children (or he) doesn’t have a student loan in five years. Paying off other consumer loans would also be at the top of the list. Getting rid of these will reduce the amount of money he needs to pay out each month, giving him security in the case of a job loss, medical condition, or other life event.
2) Put $10,000 into a bank account for emergencies. Everyone should have enough cash on hand to handle events that come up.
3) Invest the remainder in mutual funds with about 40% in income producing securities. This could mean putting about 60% of his funds in a growth and income fund (which would contain both growth and income securities), 40% in a bond fund, or maybe 20% in a bond fund and 20% in a utilities fund. The remainder should still be invested in stocks to grow wealth, but a smaller percentage should be small stocks since they are more volatile. For example, one possible portfolio might be 40% in a bond fund, 25% in an international stock fund, 25% in a large cap fund, and 10% in a small cap fund. Individual stocks could still play a role, perhaps building up 5-10 $10,000-$25,000 positions in some big companies that pay a decent dividend like Wal-Mart, Home Depot, Procter and Gamble, Intel, or MicroSoft as part of the portfolio. A couple of small growth stocks could also be added, but exposure should be limited since this investor has less time to wait for the companies to grow. Note that Matt should be contributing all he can to tax-sheltered accounts like 401K and IRAs and be buying his income producing assets in those accounts where they will be sheltered from taxes. Growth stocks should be in the taxable portfolio since these will grow tax deferred anyway so long as Matt doesn’t do much trading.
4) Withdraw some money periodically to supplement lifestyle, but take it easy. With less time for the portfolio to grow before retirement, a lot of spending could lead to issues with having enough money to make it through retirement. Matt could probably withdraw about 1% of the portfolio value per year, or about $10,000, to add to his income, but he really wants to let most of the money compound and grow. Left largely alone with a 40% income, 60 \% growth portfolio, Matt should be able to grow his portfolio to between $2 M and $3 M before retirement age, which would provide a secure retirement.
Case 3: 65 year-old:
Our third case is a 65 year-old retiree we’ll call Barbara. While a million dollars may seem like a lot, it really isn’t that much when looking at a 25-30 year retirement with medical expenses. Barbara must therefore be very cautious with her money, particularly in the early years. She will still need to invest some of her money in growth stocks since inflation will erode her purchasing power if she just keeps everything in cash. There is also recent evidence that she should start out more cautious and then get more aggressive with her investing as time goes on since a big loss early will hurt a lot more than a similar drop later on. Here are some steps that Barbara should consider:
1) If she owns her home free-and-clear, she might consider selling and trading down. She can build up more cash for living expenses, reduce her property taxes and maintenance costs, and generally make things easier. If this is not an option for sentimental or other reasons, a reverse mortgage is another option to gain some cash from her home to use as a second income source and avoid the need to sell stocks in her portfolio at depressed prices should a market drop occur. Note that this would result in her selling her home for far less than she would receive if she simply sold her home and traded down, and it is very likely that the reverse mortgage lender would own all of the equity in the home when she died or went to a nursing home. This is not an option I would prefer, but it might be an option if staying in your home is worth paying a bit extra and you can accept not leaving your home to your children.
2) She should eliminate all debts and reduce expenses as much as possible. People in retirement certainly don’t need to be paying credit card or car loan interest.
3) She should build up a big emergency fund of 3-5 years’ worth of expenses. This would provide money for living expenses should a market downturn occur.
4) She should invest a portion of her account in income producing securities. This would be bond and high yield mutual funds as well as dividend paying stocks, REITs, and other assets. Rental real estate is another option that can generate some regular income. Holding more cash reduces the need for income producing assets and vice versa. If Barbara had 5 years’ worth of cash, she might keep 30-40% of the rest of her portfolio in income securities. If she only had 2 years’ worth, she might keep 50% in income securities.
5) She should invest the remainder in stocks, with the balance spilt between large caps and international stocks. A small percentage, like 5-10%, might be kept in small cap stocks.
6) She should consider products such as annuities to provide a steady income stream. Some annuities kick in at a late age, like after the investor turns 85, and pay a lot more than they would if they started paying as soon as they were purchased. With any product like this, however, the insurance company will make more on average than the buyer, so you are paying a fee to shift risk from yourself to the insurance company.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.