How to Invest a Windfall

The other day, I ran across an interesting article by Rick Ferri about how to go about investing a lump sum of cash. Should you dump it all in the market at once, or should you dollar cost average? Based on historical data, your highest expected return comes from investing it all at once.

Of course, with higher expected returns comes more risk — and they’re just that, expected. While dollar cost averaging might reduce your expected returns, it also prevents you from investing it all at just the wrong moment. As such, many people would be more comfortable deploying their cash a little at a time.

For his part, Ferri suggests that you ask yourself four questions.

How big is your windfall?

For starters, if your windfall is relatively small relative to your existing portfolio, Ferri suggests that you invest it all at once in your target allocation and be done with it. Ferri’s rule of thumb is 20%. If it exceeds that 20% of your current investments, then go to the next question.

Was this money from a pension plan payout?

If the money comes from a lump sum retirement payout, then the cash was presumably invested in the stock or bond market prior to the distribution, and it should go straight back in at your target allocation.

Was the money from the sale of a business or property?

If yes, then the money was previously exposed to market risk, and Ferri suggests investing half the money today and then dollar cost averaging the the balance over the next two years. In his view, this spreads out the “entry-point risk.”

Was the money inherited or won?

Finally, if the money comes from a source where you had no previous ownership — such as an inheritance or lottery winnings — Ferri suggests investing 40% now and then dollar cost averaging the remaining 60% over the next three years.

Beyond the above, he also suggests the possibility of revisiting your target allocation depending on how big the windfall is. If it’s less than 20% of your current savings, then you probably shouldn’t bother changing your allocation. But if it’s more than that, you might want to revise your overall investment strategy.

The thinking here is that with a much larger nest egg, you probably don’t need to take as much risk to meet your goals. In other words, your risk capacity has been reduced, and you might want to shift to a more conservative portfolio.

While the specific rules he lays out strike me as a bit odd — e.g., why DCA half over two years in one case vs. 60% over three years in the other case? — he also makes some points that are worth considering.

For starters, if it’s not a huge amount relative to your current nest egg, don’t sweat it. Just dump it in the market and move on. At the same time, if it is a significant amount, then consider the source, and also consider its implications for your investment strategy going forward.