Expecting a Windfall? Diversify Your Investments for Greater Long-Term Gains
-Choose a wide range of investment vehicles for stability, profits, and peace of mind
Whether you’ve just won a massive lottery prize, you’re expecting a sizable inheritance, or you’re about to receive a significant amount of money from a legal settlement, you’ll have to make a lot of decisions about how to manage your newfound wealth. One of the most important choices you’ll make during this process is where, how, and how much of your money to invest – and like the old saying goes, “don’t put all your eggs in one basket.”
Unfortunately, some individuals who gain their wealth quickly do not understand the basics of safe and effective investing, and therefore decide to invest much of it into only one or two vehicles. Doing this can leave these individuals extremely vulnerable to fluctuations in stock, bond, and real estate prices, tax issues, accidents, scandals, and other mistakes – any of which could send their portfolio tanking if it’s not properly diversified.
-How to diversity your portfolio
When it comes to investing, there are a variety of ways to diversify a portfolio. One of the most common ways is to purchase investments from multiple asset classes. An asset class is simply a term used to talk about one of many different types of investments. For example, stocks, bonds, mutual funds, exchange-traded funds (ETFs), money market accounts, certificates of deposits (CDs), and real estate are all different asset classes.
-Basic Definitions
-Risk vs. reward
While there are always exceptions, in general, the higher potential return a particular investment provides is directly proportional to the risk it carries for the investor. For example, a bank account is extremely low risk; the Federal Deposit Insurance Corporation (FDIC) insures nearly every U.S. bank account for up to $250,000, yet investors may not be able to expect more than a 1-2% annual return at the very best. On the other hand, stock in a ‘hot’ technology startup may go up 200% in one year, but there’s a reasonable chance that the company could go bankrupt, leaving your stock worthless.
-Determine your appetite for risk
Understanding how much risk you are willing tolerate is key to determining which asset classes you should invest in and how much you should invest in each type of class. An investor’s risk tolerance will usually be higher if they are younger and have many years to grow their investment portfolio, while it will often be much lower for older investors who may need to withdraw large sums of money in the near future to pay for family, retirement, and medical expenses.
Risk tolerance is also determined by personal and psychological factors. Some people become extremely nervous or agitated when their investments fall in value, even if it’s only for a few days. In many situations, these people will sell an investment out of fear during a small downturn in the stock market, even if the fundamental value of the investment in question hasn’t changed. This type of emotional selling can be disastrous over time, so it’s recommended that people with a lower risk tolerance stick to investments that are much less likely to fluctuate.
On the other hand, some investors don’t care if they’re portfolio drops 50% in one day, as long as they’re reasonably confident that their investing strategy will succeed in the long run. These highly risk-tolerant investors are more likely to be able to handle fluctuations in their portfolio without making rash decisions, and can often profit more off riskier investments.
-If you’re younger and more risk tolerant, consider creating a growth-focused investing plan
Younger investors, especially those with higher tolerances for risk, may wish to purchase more volatile investments due to the greater potential returns they may be able to provide. While investing in individual stocks may be risky for investors at any age, younger investors should usually focus on a higher proportion of stocks to bonds when compared to older investors. Younger investors may want to invest in the stocks of smaller companies with more potential for growth, as well as mutual funds, index funds, or ETFs focused on investments in these smaller companies.
-If you’re older and more risk averse, consider creating an income-focused investment strategy
In general, older investors will want to purchase and hold safer and more reliable investments – and are usually willing to forgo the chance of higher profits to do so. That’s why bonds are very popular among older investors; they simply count on a company paying off its debts and they are much less vulnerable to fluctuations in the stock market than most other kinds of investments.
When it comes to stocks, older investors usually prefer to buy shares in larger, older, and more established companies. Many of these companies pay dividends to investors one or more times a year. Companies that pay dividends to investors distribute a certain amount of money per share to each investor in the firm, usually send via a check in the mail. If an investor owns enough stock in one or more dividend-issuing firms, they may be able to generate a significant annual income from dividend payments alone. Many older investors purchase a lot of high-dividend stocks in order to follow what is often called an income-based investing strategy; by doing this, they may be able to live on just dividend payments while allowing the principal amount of stock they originally purchased to keep growing over time.
Depending on the economy and interest rates, older investors may also want to consider purchasing money market accounts or CDs. Both these investments involve loaning money to a bank or financial institution for a fixed period and stipulate that if an investor tries to take the money out before the agreed-upon time, they will often pay a significant penalty.
While CDs offer a fixed rate of return established before the account is opened, the rate of return for a money market account fluctuates over time. Typically, money market accounts offer lower rates of return, but they are often more flexible about allowing investors to take out their money early, and may have less or no penalties for doing so. Currently, however, CDs and money market account returns are extremely low – which makes them an unpopular investment (at the moment) despite their relative safety in comparison to stocks and bonds.
-Understand the risks of stocks and the motivations of brokers and financial advisors
Even if you trust the recommendations of your broker or financial advisor, in most cases, individual stocks should only be purchased by investors who plan to commit serious time and study to the stock market. Otherwise, most will want to consider buying mutual funds, many of which are already extremely diversified between stocks and bonds in different industries and of different sizes.
While many brokers and financial advisors may helpful, it may not always be in their best interest to give you good advice; some may try to sell you certain products to get special bonuses or commissions –incentives that you may not know about when they issue a recommendation. Unethical brokers and advisors sometimes ‘churn’ their clients’ accounts (executing unneeded trades just to get commission fees), so you should be very careful to keep a close eye on the activity. In the end, trust your own research and, unless extenuating circumstances arise, never allow a broker or anyone else to control your account.
-Real estate, while it can cause headaches, is a stable source of income for many investors
Some investors choose to look beyond the stock market for part or all of their investment portfolio; and many of them choose to invest in real estate. When real estate is rented out, it’s usually considered more suited toward an income-focused portfolio, as it can provide a steady stream of cash. But it’s unlikely to meet or exceed the 9 or 10% that investors have come to expect from S&P 500 returns in recent years.
Rental income can be an excellent source of monthly income, especially as individuals in early retirement often want a way to supplement their income without selling shares in stock, funds, or other major investments. Online property rental services like AirBnB allow real estate investors to rent out their property for as little as one night a time, which can often triple or quadruple monthly rental incomes. However, it’s important to decide if you’re really willing to be a landlord before you make the leap. Landlording is hard work, and you’ll have to accept the downsides, including property maintenance costs, dealing with sudden emergencies, taking on a decent amount of legal liability, among several others.
If you are unwilling or unable to do the day-to-day work of being a landlord, you can hire a property management firm, but this may eat into your profit margins. It’s also important to note that real estate, while it can be a great source of income, is not a particularly liquid investment; if you need to get the cash value of your real estate quickly, you could be in trouble. Property can often take months to sell, and if the property market goes down, you could be stuck with your real estate for a while unless you’re willing to sell it for a loss.
-Know what to realistically expect to avoid getting ripped off
Historically, the S&P 500, a major benchmark for the U.S. stock market, has increased by approximately 9-10% each year when averaged over the last several decades. While no one can ever truly predict the stock market, if you invest intelligently, you should be able to get around this level of returns most years, especially if you decide to purchase investments whose performance closely mirrors that of the U.S. stock market as a whole – such as an S&P500-based index fund or mutual fund. You may be able to get higher returns on individual stocks and some mutual funds, but these also come with greater risk.
In general, any advisor or investment broker suggesting that an investment can provide more than 15-20% annual returns, especially if they say “no or low risk,” is probably not providing you reliable information. While it’s true that some of the best companies and funds have been able to break 20% for multiple years at a time (think Warren Buffet’s Berkshire Hathaway or Peter Lynch’s Fidelity Magellan Fund) this is incredibly rare in an industry where many companies (and most funds) can’t even break the average 9-10% return of the S&P 500.
-Keep some cash in the bank for living expenses, emergencies, and a little bit of fun
No matter what you invest in, it seems that the phrase “cash is king” will never go out of style – and for a good reason. Cash is still essential for emergencies, travel, and certain business purchases. That’s why, no matter what you invest in or how big your portfolio is, you should always keep both some money in an easily accessible checking or savings account and a small percentage of hard, physical cash as an emergency fund, perhaps in a home safe or safety deposit box.
-No matter what you invest in, be careful and do your research first
Jumping into an investment because a friend, relative, or broker suggested it can often be tempting for those who have recently come into money, but it’s nearly always a bad idea. Take your time before making a serious investment in anything, as even relatively safe forms of investments like money markets or C.D. accounts can have unanticipated risks.
To learn more about smart financial advice for lottery winners and others who need to safely invest newfound wealth, contact Nupoint Funding at 1.877.635.3149 or complete our online form to set up a free, confidential consultation.
