Suddenly rich? 5 steps to maximising your lump sum (without losing it all)

Your first financial moment of truth may have been when you first started earning an income, perhaps as a teenager, did you save any of it? Or did you use it to borrow extra money? Equally, when you started earning a full-time salary, was some of it captured for long-term savings? 

One of the key 'moments of truth' comes when a person is presented with a lump-sum windfall, for example a larger than expected tax return, an inheritance or a significant gift or prize. 

Lump sum losers

Stories of lotto winners who end up losing their lump-sum are almost a cliche. Last year the New York Post profiled winners of large lotteries - Jay won $5 million in the mid 1980's and spent it on a NASCAR dream and legal battles, Ronnie won $3 million and ended up in jail for drug offences and Evelyn won $5.4 million, lost it on risky investments and lives in a caravan.

Whether the lump sum is a $3,000 tax return or a $2,000,000 lotto prize, the underlying challenges persist: How will the money be managed? What are some prudent steps you can take to make the best of that windfall and capture a long term financial benefit? 

To avoid 'wasting' a lump-sum like the aforementioned lotto winners did, I propose there are 5 steps worth considering.

1. No need to make a snap decision - take your time 

There should be no pressure to make a snap decision about what to do with a lump-sum windfall. With cash accounts available that provide you interest at the rate of around 5%, in the ballpark of the current rate of inflation, you can park your money and be earning interest while you consider your next step. Have a good cash account ready to go, put the money there and there should be no rush to make a decision. 

2. Financial literacy 

In the decision-making process around the use of a lump-sum, the person most passionate about getting a great outcome is likely to be yourself. Taking some time to build your own financial literacy, so that you can keep a watchful eye on what is happening with your funds, makes a great deal of sense.  The InvestSMART 'Bootcamp for Beginners' is a great place to start. 

3. The value of advice

There are two layers of decision making that will come with a lump-sum: 

a) what personal finance strategy is appropriate? 

b) what investment strategy is appropriate? 

Finding an independent, fee-based advisor to help you with the strategy and investment decisions at the time of receiving a lump sum might add value to your situation. 

For example, the strategic decision between paying more money to the mortgage, setting up some investments outside of superannuation or making a superannuation contribution (or series of contributions over a number of years where tax-deductions are claimed), is an important one, and one that an advisor should be able to add value to decision by explaining the pros and cons of each approach. 

Equally, a qualified and experienced professional to discuss the investment strategy makes sense. 

4. Your market timing decision 

Once you have made the decision about the personal finance strategy you are going to adopt, the next is the investment strategy. A strategy around low-cost index/ETF style investments may well be the approach taken, with the benefits of diversification within and across asset sectors, low costs and simplicity. 

Regardless of the strategy chosen, there is also a market timing decision to be made. Is the lump-sum to be invested at the one time, or might a 'dollar cost-averaging' approach be used, where smaller amounts are invested regularly, building the portfolio over time? 

There are two advantages to the 'dollar cost-averaging' approach: 

1. It takes away the risk of investing just before a significant market downturn and facing significant losses.  For example, some poor folks invested sums of money the day before the 1987 sharemarket crash, or at the peak of the 2007 pre-global financial crisis bull market, or just before the 2020 covid downturn.  It we look back historically, there are terrible times to invest - choosing to invest by using small amounts, invested regularly (for example every two months over the course of three years), provides some protection against the impact of a sharp market downturn. 

2. Even without a sharp market downturn, there is the tendency to panic when normal market volatility pushes prices down.  A less experienced investor, or one who has not had a large sum invested in the market, might be better to get a sense of market volatility through the investment of smaller sums of money initially.  This is better than investing a lump-sum at the one time, being impacted by volatility and 'panic selling' with losses in the portfolio.   

There has been a variety of research on the topic, consistent with the Vanguard report that shows that cost averaging reduces the expected returns from a portfolio as it is being build, and also reduces the portfolio volatility.  There is no correct answer in the lump-sum vs cost averaging debate, and decisions can suit individual preferences. 

5. Keep expectations realistic 

I suspect that part of the reason lotto winners find themselves losing it all is that a lump-sum seems to overstate the financial possibilties. A person who wins $5 million tomorrow will feel like they should live a champagne lifestyle into the future - however if that portfolio generates income (after costs) of 4% per year, and assuing an average tax rate of 25%, a $5 million lump sum provides after-tax income of $150,000 per year.  

$150,000 per year from a lump sum is an extraordinary amount of money, however it seems more modest than the headline $5 million figure implies. If you work on a 4% per year drawing rate a $3,000 tax return becomes a $150 per year contribution to future expenses, a $100,000 lump-sum provides $4,000 per year and a $500,000 lump-sum $20,000 per year.  These lump-sums provide a useful level of ongoing income, rather than the ongoing promise of a lavish lifestyle. 

Maximising your long-term financial benefit

As financial 'moments of truth' go, the decision around what to do with a lump-sum is an important one.   

Not rushing, thinking about the importance of financial literacy, accessing independent advice, thinking about whether to slowly expose the capital to investment markets, and keeping an eye on the value of the income from the lump sum are all ideas that might support good decision making - putting you ahead of lotto winners who blew their fortune.