How to Invest a Large Inheritance

Investing an inheritance is different from investing income from work or sale of a house.  Some individual in your life has made a very generous gift to you in an effort to make your life better.  There is therefore a sacred trust that goes along with the money.

One would therefore like to use the money wisely.  One would like to preserve it such that the money can last.  Ideally the principle would remain and just the interest used to aid with expenses and purchases.  Given a large enough inheritance and prudent management, the money can last and benefit not just the primary beneficiary but heirs for generations to come.  For example, the money could be set up as a trust fund that pays for members of the family to attend college or buy their first homes.  Managed correctly, a substantial inheritance can last generations.  Managed poorly, it will not last out a decade.

If one is fortunate enough to receive such a gift, here are the steps to follow to make the money last:

1.  Never spend principle, only interest.  As long as the principle is never touched the amount will not decrease.  In general one can expect to withdraw about 8% each year without affecting the value of the account.  For example, if one receives $1 Million, one should expect to receive an income of up to $80,000 per year.  This assumes that the account is invested in stocks, which earn an average of 10-15% per year.  After withdrawing 8%, the remaining gain is used to battle the effect of inflation.

Another strategy, if one does not depend on the income, would be to withdraw nothing on years where the return is 10% or less and withdraw the total return minus 5% on years when the return exceeds 10%.  In this way money is only withdrawn when the return on the account is more than enough to make up for the withdrawals.

2.  Diversify.  The secret to preserving wealth is diversification.  By spreading money out into different types of investments, decreases in one type of investment will be offset be increases in another.  A smaller account (less than $500,000) should include stocks in several different sectors of the market including international stocks.   For example, buy index funds that include large caps, small caps, international stocks, bonds, and income producing stocks (think utilities).  Larger accounts should include some real estate as well, either directly or through the ownership of REITs.  One possibility would be to pay cash for a vacation house that is rented out most of the year.

3.  Invest in ways that beat inflation.  As mentioned in the first step, investment in common stocks and other inflation beating vehicles is needed.  Left in a money market account the funds will wither and decline with time.  Investments in hard assets such as gold will preserve the wealth but will not outpace inflation.  If you are planning to leave your wealth to your descendants five generations down the line with no one to care for the money, gold might be the answer.  Otherwise, stocks and real estate will do better.

With principle preservation, diversification, and investments that beat inflation, that inheritance can last your whole life and for many generations to come.

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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. 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.

Mid-Life Investing – How to Diversify and When to Start to Diversify

 In this post I’ll continue with the steps for investing.   This is part of a series of posts on How to Make Returns that Beat the Market that starts here:

http://smallivy.wordpress.com/2010/08/31/a-strategy-for-market-beating-returns-in-the-stock-market-introduction/

Earlier posts in this series dealt with an individual in his (or her) early twenties or thirties who was just starting to invest.  This individual was being smart in his financial life – having no credit card debt, renting or buying a house with 20% down and a payment of no more than 25% of his take-home pay.  He was also putting money away regularly in his work’s 401K plan and perhaps a personal IRA on the side.  Because he had relatively little to invest, he had little to lose.  This, combined with a long time horizon that allowed for recovery from mistakes and just plain-old bad luck meant that he could be aggressive with his stock investment.

Being aggressive did not mean being foolish.  He would still invest in a way that would put the odds in his favor.  This included investing for the long-term where growth in stock price could be expected to follow the growth in intrinsic value of the stock he was buying.  Likewise, he was buying shares only in companies with steady earnings growth, good management, and room for continued growth.  He wasn’t trying to time the market or playing various games since he knew that those games were stacked against him. 

The risk he was taking was concentrating his holdings in a few great stocks rather than spreading his money out over several stocks or buying an index fund or mutual fund and just accepting market returns.  He was concentrating his investments in a few companies that he believed would outperform their peers over the long-term.  Because bad things happen to even good companies — officers steal money or cook the books, new regulations are created that hamper the business, competition emerges that takes a large amount of the company’s market share, or they drill a hole in the bottom of the ocean and kill everything in the area he is taking the risk that one of his selections could decline substantially in value.  The price of the shares of any individual company can decrease rapidly or even become worthless in a short amount of time. 

Likewise, while the entire market does not increase in value that rapidly, averaging about 10% per year, it is not uncommon for individual stocks to double or even quadruple in the period of a year.  If one is fairly good at picking stocks, one can therefore make up for one or two bad stocks that go nowhere or even disappear  with one great stock that goes up twenty-fold over a period of 10-20 years.  In the early stages, our young investor is trying to find one of these stocks to make his meager holding grow rapidly.

As this investor continues to buy shares, however, he should reach a point where he does have enough money to protect it.  He may have 5 of 6 large positions worth about $50,000-$100,000 each, with an account balance of about half a million dollars.  (One should also note that an investor who starts with a large account would apply the same strategy that follows by only investing a portion in individual stocks).  At that point he should start diversifying his holdings to reduce risk.  As stated before, diversification reduces risk because holding a basket of stocks or other investments reduces the damage done by the collapse of any one asset and  the advances by some stocks in the portfolio will offset the losses by other stocks.

The amount of security depends on two factors:  1) The number of different positions held, up to a limit of about 50-100, and 2) the amount of covariance among the holdings. 

To achieve a larger number of positions, the easiest method is to take a portion of the portfolio and put it into mutual funds.  Because their cost is low and they perform as well as most managed funds, index funds are a good choice.  To determine the amount of funds to put into index funds, simply use your age.  If you are forty, you should have about 40% of your funds in diversified mutual funds.  When you are sixty, you should have about 60% of your funds diversified into mutual funds (with about 5 years’ worth of expenses in cash as well).

The covariance is a factor that determines how the different assets you hold tend to move in the same direction.  Two holdings with a covariance of 1 would move in lock-step.  Likewise, two with a covariance of zero would move with no relationship.  Finally, two with a covariance of -1 would move in exactly opposite directions where one would go down 10% if the other went up 10%.  Ideally, covariance should be about zero aqmong the various holdings in a well diversified portfolio.

To achieve a portfolio of assets with low covariance, buy funds in different asset categories.  For example, buy a large cap fund, a small cap fund, a bond fund, an international stock fund, and a real estate fund (REIT).  One could also toss in a commodities fund in small amounts if inflation was a concern.  Buy some funds that pay a large dividend (ideally hold these in an IRA to protect yourself from taxes) and buy others that pay almost no dividend but hold a large number of growth stocks.  You can also select managed funds that try to buy based on value (an example would be a “Dogs of the Dow” fund ) and another that invests based on momentum.

In the next post we’ll look at what to do as our investor nears retirement age and need to start setting up the portfolio to live on.  Next post in series: http://smallivy.wordpress.com/2010/09/21/how-to-structure-a-retirement-portfolio-and-preserve-funds-to-last-out-retirement/

This is one of a series of posts in the category of ”Making Market Beating Returns.” See the rest of this series: http://smallivy.wordpress.com/category/making-market-beating-returns/

Much as I enjoy writing about investing, it doesn’t make sense unless people are reading. If you’d like to keep the articles coming, please return often and refer a friend – http://smallivy.wordpress.com.  Comments are also greatly appreciated, as is lively and friendly debate.  Also feel free to link to or reference posts – all I ask for is fair credit.

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. 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

The Stages of Investing

The main strategy promoted by this blog is one designed for growing wealth.  The strategy involves picking stocks that have potential to grow at a steady pace for many years and buying fairly large concentrations of those stocks (basically, as much as you would be willing to lose in any one stock) and then holding those positions as long as the company remains a steady-growth company.  The premise of this strategy is that if one Microsoft, Home Depot, or Walmart is found, that then grows thousands of percentage points over the next 20-30 years, one can afford to take a loss in some of the other positions. 

Because a relatively small number of individual stocks are being purchased, there is less diversification than would typically be recommended.  The idea is that we are willing to take more risk because it is worse to miss out on rapid growth of capital than it is to have a few losses.  Note that this is true if three things are the case:

1. We don’t have a great deal of money at stake to begin with, so some loses it won’t set us back that far.

2. We are committed to constantly diverting some of our earnings to investing so any losses are replaced with fresh investment money so that we won’t miss out on the next big thing.

3. We have enough time to recover from losses.

Note that because of the third requirement, this is not a strategy for an individual who is close to retirement.  Assuming this person will not have another income, he therefore will need to money to live on.  That person could therefore not afford to suffer a large loss.  (Note that such a person might apply the strategy with a limited amount of savings, for example if he had $2 million he might spread $1.8 million out over a set of mutual funds and use $200,000 to by concentrated positions in 4-5 good growth stocks.  This would provide needed diversification for the bulk of his savings.) 

Below are the Stages of Investing – The types of investment by status in life.  This assumes that the individual starts out with relatively little, but has a decent paying job.

Stage 1– Early Career (Ages 16-30):  During this time be putting away money religiously.  Obviously you don’t have a lot of money to spare, but do your best to live below your income and save something each month.  (One secret is not buying new cars – a quality car that is 4-6 years old can be bought for cash for $4000-6000, will require far less maintenance than you think, last for at least 5-8 more years, and save you $4000 or more a year on interest and depreciation.)  After you have put 10-15% away in a 401k, and saved $10000 or so in a cash account for emergencies and handling life’s little surprises, put away what you can in an investment account.

Because you don’t have a lot to invest, you should be more concerned with growth of capital than capital preservation in this investment account.  Using the stock picking pointers from my previous post, start buying large positions in the companies you feel should provide steady growth.  Add to these positions until you’ve bought as much as you would feel comfortable in losing, and then add more stocks as you go to your portfolio.  If you have a big winner, sell a bit and use the proceeds to buy shares in other stocks, but in general let your winners ride.  If you are wrong some times, sell the losers, write them off against your winners (and up to $3000 of your regular income) and learn from your mistakes. 

Stage 2– Late-Early Career (Ages 31-45):  By this point you should have seen your portfolio growing to the point that you have some real money in your accounts.  If you have been a diligent saver, as defined by The Millionaire Next Door, you will have a net worth of at least (Your Age)x(Your Income)/10, for example, a 40 -year old with a $80,000 income would have a net worth of at least $320,000.  You should have about 10-15 stocks and some fairly large positions in your portfolio ($40,000-$100,000).  Hopefully you’ll have a stock or two that is almost all profit.

At this point you need to start looking at some capital preservation.  You do this by shifting some of your funds into mutual funds to get diversification, and some into smaller positions in large stocks of companies that aren’t growing rapidly but are mature enough to have obtained stability and predictability.  These stocks will probably pay a decent dividend and grow maybe 5-10% per year, for a total return of maybe 10-15%.  You will still have some large concentrated positions for growth (maybe 50-75% of your portfolio), but you position yourself to hang on to what you have made.  Your 401k should also be in the hundreds of thousands by the time you reach the upper ages of this range.

Stage 3– Middle Career (Ages 46-58):   Here you should be in your prime earning range at work.  You will probably have some significant expenses, like college, weddings,  and more elaborate vacations.  Hopefully you will have taken out a 15 year mortgage and be paying it off by this point.  You also should become a millionaire during this time and wonder why you used to think a million dollars was a lot of money. 

Despite your expenses, you should still have ample funds for investing, having paid off your house.  You should be maxing out your 401k, putting a large amount of money in your investment account each month.   Your investment account, however, should be returning as much or more than your job.  Note that this means that you should be doing something you like doing, because you are no longer working just for money to live on.  Enjoy some of this money, but allow a great percentage to reinvest in more assets and continue to grow. 

Keep moving some of your funds into more diversified areas (mutual funds, quality stocks, bonds, REIT’s, a vacation home).  By the time you are 58 you should have at least 60% of your money well diversified, with the rest concentrated but still in amounts you can afford to lose, maybe $50,000-$100,000 amounts at the most.  Remember also that the market can and does go down for periods of up to 10 years at a time, so you should have a year or two of savings in a nice, boring bank CD by the time you reach the end of this range in case the market decides to crash and mess up your retirement.

Stage 4– Late Career (Ages 59-70):   Here you are finishing up your career, maybe working beyond 65 just because you just want to.  Your 401K and IRA accounts should have several million dollars in them, as should your investment account.

By this point most of your money should be well-diversified, including a number of mutual funds – some of which provide growth and other which provide income for expenses.  Because you have so much money, you will also have a number of individual stocks.  Some growth stocks, some larger more stable companies that pay good dividends.  You will also own bonds, REITs, convertibles, and other assets.

Here, if you wish, you can put a small percentage of your money in concentrated positions on stocks you like.  By this point it is merely for entertainment, because you really don’t need the growth.  You also have enough money to buy some small positions in things like penny stocks (maybe $5000).

Note that if you started later, didn’t put money away, or don’t have the large accounts listed for some other reason but are in that age range, you should only have the very diversified portfolio because you’ll need to make sure you preserve all you can.  You should also be working hard and saving all you can.

Stage 5– Retirement/Second Career(Ages 70+):  Hopefully by this point you’ll have plenty of assets to live on comfortably.  Keep the diversified portfolio, with maybe a little money concentrated in growth stocks as listed for Stage 4.  Set the portfolio up so that you receive enough income to not need to sell shares very often (although if taxes on interest are high compared to capital gains it may be better to sell a few shares here and there to gain living expense money).  Make sure you have spread funds out to guard against devastating events, like fraud, bank collapses, etc…, because these are the only risk you really will be facing.

If you have less assets than you would like, you should still have the diversified portfolio to preserve what you have.  Unfortunately you’ve lost the luxury of time, which reduces the risk of being more concentrated.  You should also have sufficient assets liquid (in a savings account) to pay for expenses for at least 5 years since you won’t be able to sit through market downturns since you’ll need your portfolio for living expenses.

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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.  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.

Preserving Wealth

As stated previously, the main goal of this blog is to communicate how to invest to grow wealth quickly and beat the average mutual fund.  This strategy is for those who don’t have a great deal of wealth, such that the threat of losing at some positions is less important than being too conservative and settling for a low return. 

But what about those who do have enough wealth to worry about its preservation.  What if you have a million dollars in the bank and are looking to retire in a few years?  While a portion could still be invested in individuals stocks to obtain growth, say $100,ooo of the million, it would be unwise to put such a large portfolio at risk since the money will be needed soon.  Today I wanted to talk a bit about wealth preservation, instead of growth.

One might figure the best thing to do would be to put the money in a CD, or maybe under the mattress, since protecting the nest egg is the goal here.  (This is in fact exactly what should be done with funds needed within the next five years since investments in the stock market can be underwater for several years at a time.)  The trouble is, unless wealth is stored in a hard asset like gold, inflation will be eating away at the value all the time.  It is therefore necessary to make about 3-4% per year to prevent loss of purchasing power – and more at higher inflationary times.  Even investing in gold is not a sure thing because gold is subject to bubbles and falls (we may be in a bubble now).  If you’d  bought gold during the height of the bubble of the 1980′s it would have taken 20 years to get back to the same price.

Wealth preservation is all about diversification.  Because all industries do not tend to go down at the same time, one wanting to preserve wealth should buy mutual funds that purchase stocks in a wide variety of industries.  Also, buy funds that invest in different sized companies (small, mid, and large caps) and also international funds, since the stock markets at other parts of the world may be doing well even when the US market is not, and stocks in foreign countries will also increase when inflation increases here.  Putting some money into non-stock investments, such as REITs, bonds funds, and preferred convertible stocks and bonds would be wise since the relatively large interest/dividends that these types of investments pay help reduce the size of the fluctuations they experience.

Refer a friend – link to this page: http://smallivy.wordpress.com

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.  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.