A friend of mine recently came into an inheritance. Surprisingly, he sought my advice.
At that moment, I was reminded of an interview Oprah did with billionaire author JK Rowling. In that conversation, Oprah asked, “What has money done for you?”. Rowling’s reply was memorable:
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“It frees you. That’s what it does. It frees you. That’s why it’s like a super power.”
Many of us dream about financial independence, but it is not so much the notion of becoming rich itself. To put it in superhero terms, with great power, comes great responsibility. My friend hesitated to ask for advice, and it is no surprise. There could a lot of well-meaning alongside some not so well-meaning advisers ever so eager to present you a biased buffet of financial options.
A Happy Problem
Still, it is a happy problem many would be eager to handle (myself included).
In my view, there are broad two principles of investing a large sum of money. The first way is avoid putting all your eggs in one basket. Investing in property is an option. However, property returns in the past is supported by Singapore’s population growth from 2.4 million in 1980 to 5.5 million today. To expect similar results in the future may not be realistic, in my opinion.
For me, there is little doubt that equities is an asset class should be considered. Historically, stocks have delivered higher returns compared to than all asset classes over extended timeframes. But even if we choose to invest in equities, another problem arises: Should we invest a lump sum of money or should we spread out our investments over time?
Art And Science
For many years, the conventional wisdom has said that if you have a large sum of money to invest, you should spread out your investments across a long period of time. The approach was termed dollar cost averaging (DCA). In doing so, we limit our downside risk by averaging out your purchase price.
However, two Vanguard studies in 2012 and 2017 has turned conventional wisdom on its head.
The argument goes as follows: Given that equity returns have always been higher than other asset classes (cash investments and bonds), lump sum investing (LSI) allows one to gain exposure to the market as soon as possible.
In their 2017 study comparing LSI against DCA, Vanguard found that LSI outperformed DCA 92% of the time over a 36 month period, and 64% of the time over a six month period. Interestingly, they found that asset allocation did not matter. Even if you invested in a 100% bond portfolio, investing immediately still beat spreading your investments across a period.
A Foolish Takeaway
If investing is an art – then great art requires both logic and emotion.
If we indeed have a large sum of money to invest today, I am sure many of us will find it difficult to invest the entire sum immediately even if Vanguard’s studies points out that it would be the logical thing to do.
If we indeed incur losses in the short-term, we might find it hard to forgive ourselves for being foolish (with a small “f”) with our hard earned money. For me, our financial independence rests on our financial education. The faster we learn, the quicker we can invest, and the earlier we can retire.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.