Last week I wrote about lump sum investing vs. dollar-cost averaging, voicing the opinion that in most cases, if a lump sum is available, it’s a better choice in the long run. But how do you invest that lump sum?
It’s great that the financial media has been encouraging young people to start thinking about investing as a part of becoming aware of financial responsibilities and future needs. The general consensus is often to put as much as possible into the stock market for the best chance for long-term growth, and without much further thought, an index mutual fund like VTSMX is the vehicle.
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That’s great for a quick start, and it’s better than not doing anything at all, but when these choices are automatic, you’re not really in control of your finances. Walter Updegrave, senior editor of Money Magazine, suggests asking yourself several questions that get to the heart of an investor’s needs and goals. The answers should determine how you should invest your money.
These suggestions are in response to a reader who asked Money Magazine how to invest $300,000 received as part of the sale of a home, assuming these proceeds are not needed to buy a new house. The strive to determine an investor’s philosophy, the true goal of these questions, is the same regardless of the amount to be invested.
The first question is significantly more important than the following two, but as you’ll see, questions two and three will have a significant effect on the success of question one.
Question 1: What am I investing this money for? Most people don’t think about their goals. The object, they may believe, is to just keep increasing their net worth. Money in a bank is great to have, but there’s no point to money unless it is being used for something, either now or in the future. A high net worth is not a goal, it’s just an intermediary step to achieving a real goal. Having investments worth $1 million (or $10 million, or $10 billion) is merely a milestone, not a destination.
Updegrave suggests determining the goal for just the immediate funds you have available, but I suggest looking broader if you haven’t already? What do you want to do with that money? Besides having enough to improve the quality of your life, do you want to improve life for the poor? Do you want to foster a wider appreciation for the arts? Do you want to own a baseball franchise? Will your money go to work building a school?
Once you’ve decided on a major goal or two, you can have a better sense of what your goal is for the amount you have available to invest today. Perhaps you can use it to get started on one of these goals, but perhaps you need a car to get around or you want to pay for your children’s college education.
Question 2: What investments do I need to achieve my goal? This is a more difficult question for the investing novice. Updegrave suggests keeping it simple by building your portfolio from just two index funds, one containing stocks and the other containing bonds. Adjust the allocation between asset types to suit your growth needs and risk tolerances.
You should have a time horizon in mind to help you determine your allocation. Without a time horizon, you will not know how much risk you can tolerate. Even the best plans often fail due to unforeseen needs, so your investments should be flexible, as well.
Question 3: What am I paying for my investments? Index funds simply match market index benchmarks like the S&P 500, so you would expect all index funds in the same category to provide you with the same gains each year. It’s not quite that simple; management fees eat into those returns, causing some funds to consistently perform better than others. The same holds true for managed (non-index) mutual funds. The solution is simple: given similar funds, choose the fund with the lowest fees.
Questions to ask yourself when investing, Walter Updegrave, Money Magazine, June 22, 2010
Updated October 21, 2015 and originally published June 24, 2010.