4 Tips for Investing a Windfall

If you've received an inheritance, a bonus, or a large financial surprise of some kind, follow these four steps

Christine Benz 19 December, 2011 | 10:40AM
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It's often called "The Lottery Curse," and it refers to the many tales of lottery winners who went on to lose their windfalls--or worse. Theories abound about why those who experience positive income shocks, such as lottery winnings, subsequently struggle, ranging from the idea that recipients of large windfalls are vulnerable to financial demands from friends and family members to the hypothesis that lottery winners are more likely to engage in costly and unhealthy vices.

Yet lottery winners aren't the only people subject to positive income shocks: Children and grandchildren routinely receive large inheritances, newly married couples often find themselves with substantial gifts of cash, and employees might receive bonuses that represent a large share of their earnings for the year. Each of these situations is different, of course, and so is the best course of action for the windfall. However, there are some overarching concepts to keep in mind to ensure that your windfall helps to further your financial well-being rather than dragging you down.

Follow these steps if you or someone close to you has received a large influx of cash.

Step 1: Keep It Safe and Segregated
If you've read anything about windfalls, you know that the cardinal rule is to be deliberate, resisting the urge to invest or spend the money all in one go without due consideration for the options. That's certainly true. But don't tuck your cheque in a drawer as you size up the possibilities. Instead, park it in a cash account--a money market fund or a savings account, for example. It won't earn much interest there, but it will at least be safe. Also take care to segregate the windfall from the cash you use for daily living expenses; in other words, don't pop it into your current account, where it could slowly ebb away as a result of the drip-drop of dinners out, gifts, and supermarket bills.

Step 2: Splurge Within Limits
For many lottery winners, their undoing was squandering the dough on impulse buys that provided short-term gratification but little else. It goes without saying that you want to avoid that trap, but a small splurge needn't be verboten, provided you set limits. Consider earmarking 5% or so of your windfall for "no strings attached" spending, including gifts to loved ones or gifts to yourself. By setting aside a fixed amount, you're more likely to put serious thought into what you spend the money on, and you'll think twice about spending more than that amount on frivolous expenses.

Step 3: Review Your Household's Balance Sheet
Once you've parked your money in a safe holding place and carved out a small amount for short-term gratification, the next step is to take stock of your household's financial balance sheet. Morningstar.co.uk is an investing site, but I'm the first to acknowledge that, depending on your situation, investing in the market won't necessarily give you the biggest bang for your buck.

High-interest credit card debt is a no-brainer; paying it down should trump investing every time. Meanwhile, other types of debt--loans without egregious levels of interest or those on which you receive a tax deduction--occupy a grey area; this article provides some considerations to bear in mind when determining whether to pay off debt or invest. Don't let your balance sheet analysis stop there, though. Also assess whether you have adequate liquidity reserves; this article includes some guidelines. Finally, if ignoring a home or auto repair will cost you more in the long run if you don't address it soon, prioritise such expenses before investing.

Step 4: Get a Plan for Putting the Money to Work
If you've reviewed your household's balance sheet and have decided to invest all or part of your windfall, the next step is figuring out where to put it. Resist the urge to think of your newfound cash as so-called mad money in the hope that you'll be just as lucky investing it as you were to receive it in the first place.

If you've already created an asset-allocation plan and taken care in selecting investments, you don't need to reinvent the wheel simply because you've received a windfall. However, if you haven't been happy with your investments or you've cobbled them together over a period of years without considering how your portfolio works as a whole, use the windfall as an impetus to do so. This article can help you identify an appropriate asset allocation given your life stage, the key step to take when developing an investment plan.

Younger, newer investors will have to wrestle with whether to invest for shorter-term goals, such as a deposit on a home, or for their own retirements. For many, the right answer will mean splitting the difference, investing for both goals at once. The Portfolio & Money Management section of our online article archive includes a wealth of articles for investors just starting out. Investors of all age groups should make sure to invest as much as they can within tax-sheltered vehicles such as ISAs or company pension schemes.

No matter what investments you choose to buy, plan to move slowly, deploying your windfall in regular increments during a period of six to 12 months, or even longer for very large windfalls. Doing so will help ensure that you don't move a large sum of money into the market at what in hindsight could be an inopportune time. Instead, you'll obtain a range of purchase prices for your new holdings.

Christine Benz is director of personal finance with Morningstar; this article has been rewritten for a U.K. audience by Holly Cook, editor for Morningstar UK.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Christine Benz

Christine Benz  is director of personal finance at Morningstar and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances.