<b>Basics Revisited:</b> Investing Your Lump Sum Without Taking Your Lumps

[Editor's Note: Many of our specialist readers are so involved in financial intricacies that it may be difficult for them to answer questions on investment basics from non-initiates. Jim Berliner's clear explanations should be useful not only in advising professionals who earn a large fee but also for any firm member or client who is faced with a major investment decision.]

In February of 2000, attorney Don Mackey was on top of the world. The seven-figure jury award he had achieved for a client in a wrongful termination case had withstood its final post-trial challenge, and his long awaited payday was imminent. After accounting for taxes, Mackey was expecting to net around $700,000, his reward for the considerable effort expended over years on the case, not to mention the inherent risk involved in taking the case on a contingent fee basis.

Mackey was also jubilant about the mind-boggling rise in the stock market during the 1990s. He had seen his portfolio grow quite nicely, to say the least. Accustomed to average double-digit annual gains and seeing the stock market hit new highs practically on a daily basis, Mackey was looking forward to putting his lump sum payment to work ASAP.

While the timing of his contingent fee payment and the level of the stock market just before the tech bubble burst were coincidental, the elements of Mackey's story are actually fairly commonplace. Many attorneys receive unusually large payments at various times in their professional careers, whether from contingent fee payments, deal closings, inheritances, or even a pension plan rollover at retirement. And while the rise and fall of the stock market in the late 1990s and early 2000s was exceptional in its magnitude, it was not unprecedented, and markets will continue to exhibit considerable volatility, providing ample reward and risk. With this in mind, what should Mackey ' or any other investor ' do when they receive a lump sum payment?

Planning and Perspective

While the receipt of a lump sum may be unique in the financial life of the recipient, the award should never be invested on an ad hoc, stand-alone basis. Instead, it should always be invested pursuant to a well conceived financial and investment plan. That plan must be firmly grounded in the investor's short-term and long-term financial goals, such as funding a home remodel or second home, financing childrens' college educations, and insuring the investor's own ultimate retirement security. In addition, the new deposit must be invested in the context of the investor's other investments to make sure that the overall portfolio maintains the proper balance and diversification.

Having a comprehensive long-term plan helps investors avoid favoring the hot investment of the moment, an option that so frequently disappoints and represents a setback in the path towards reaching one's financial goals.

Mackey's situation was similar to that of many others, in that he had multiple objectives in his financial plans. While part of his lump sum was earmarked for immediate expenses, a portion was added to his kids' college savings accounts and most was dedicated to his long-term retirement planning. Accordingly, the bulk of it was invested for long-term capital appreciation. A portion was used to make the annual contribution to his retirement plan, and the larger balance was added to the investment account containing his other after-tax savings.

Balance, Diversification and Risk Management

Much has been written about the need to adequately diversify one's portfolio, but most investors simply don't do a sufficient job. By the late 90s in particular, the market's outsized rewards for portfolios concentrated in tech stocks and other growth companies caused many investors to lose sight of the merits of diversification. Sadly, the results for many of them were disastrous.

The foundation of a solid investment plan is a portfolio that strikes an optimal balance between seeking attractive returns and effectively managing risk. The key to success is nearly always found in the overall asset allocation, first in matching the portfolio's asset mix to the investor's unique goals of capital appreciation, income (if appropriate) and capital preservation. At a minimum, the portfolio should have broad diversification within the traditional asset classes of stocks and bonds, again depending on the investor's objectives and risk tolerance. Investors should be global in their reach, embracing foreign established and emerging markets and seeking exposure to smaller and mid-size companies here and abroad to complement the traditional blue chip fare.

While most investors stop there, more can be achieved by combining “alternative assets” in a portfolio of traditional securities. There are numerous asset classes and strategies that have been attractive to own on a stand-alone basis, but tend not to move in close correlation with the stock or bond markets. These alternative assets include real estate (both direct ownership and through real estate securities), high-yield bonds, commodities, hedge funds, and private equity. Incorporating some of these strategies into a portfolio that contains stocks and bonds should help the investor improve the portfolio's reward potential, lower its risk and volatility, or as is often the case, do both.

The importance of adding alternative assets to a traditional stock and bond portfolio cannot be overemphasized. Indeed, the Nobel Prize in Economics was awarded many years ago to a group of academic economists who had demonstrated quite convincingly that combining portfolio elements that do not move in sync with one another could meaningfully improve the overall portfolio's return and/or risk exposure.

Another risk management strategy for investing a lump sum is “dollar cost averaging.” Rather than place a large, perhaps one-time payoff into the volatile financial markets all at once, the funds should be put to work over a longer period, in regular intervals over several months or longer. Through this strategy, the investor can enter the market at different times and valuations, partly reducing the risk of putting it all to work just before a potential major downturn. By dollar cost averaging, if the markets turn down after investments commence, the investor will buy more shares at a lower price, just as they will buy fewer shares when markets are rising. The average cost of purchases made over periods of volatility will be lower than the cost of shares bought during the times of higher valuations. Finally, an additional way to reduce this risk on a shorter-term basis is to begin with a more conservative investment plan, in terms of the overall asset mix, and revise it at some point in the future.

In early 2000, Mackey was understandably excited about investing more in tech stocks. After all, the opportunities presented by the Internet in the new world order seemed unlimited, and available for savvy investors to exploit. But as with every previous revolutionary economic transformation, after a manic period in which virtually everybody profited, the shakeout left a few winners and many more losers as the technologies evolved and matured. Mackey (reluctantly) accepted the advice to combine investing in this growth potential with significant commitments to other sectors, asset classes, and strategies. Fortunately, over time his more broadly diversified portfolio helped him preserve and grow his hard-earned lump sum, as many segments of the financial markets escaped the worst fallout when the markets turned south. Some even profited nicely during the long and deep bear market.

Costs and Taxes

Investing is never a cost-free exercise, and a sound investment plan pays close attention to transaction costs and advisory fees. This can make a huge difference over long periods of time, and a vigilant investor will come out ahead by avoiding unreasonably high investment expenses.

For most individual investors, the biggest investment cost turns out to be taxes. Investors should seek to delay the realization of tax liability as long as possible, through low turnover and longer holding periods. That way, the ultimate tax liability will be tilted more towards the lower rates of long-term capital gains. Qualified dividend income also now enjoys that preferential tax rate.

Employed investors like Mackey may also be able to shelter some of their lump-sum payments into qualified retirement plans, like profit sharing or defined benefit plans. This will lower their tax liability on the amounts they receive as earned income and place some of their assets into accounts that are tax-sheltered while they are growing.

The period from February 2000 to the fall of 2005 has been a tumultuous time for the financial markets, marked by extreme highs and lows. Yet having a sound investment strategy, grounded in strategic diversification, risk management, and an attention to costs, helped Don Mackey navigate a steadier course through the turbulent waters. The lump sum payment that he received five years ago is still hard at work, worth considerably more now than when he started at the market peak in 2000. Just as Mackey worked zealously to win and defend a favorable award for his client, by having a comprehensive and effective approach to investing, his portfolio has earned solid returns while effectively managing risk and helping him make great strides on the road to achieving his financial objectives.

[Editor's Note: Many of our specialist readers are so involved in financial intricacies that it may be difficult for them to answer questions on investment basics from non-initiates. Jim Berliner's clear explanations should be useful not only in advising professionals who earn a large fee but also for any firm member or client who is faced with a major investment decision.]

In February of 2000, attorney Don Mackey was on top of the world. The seven-figure jury award he had achieved for a client in a wrongful termination case had withstood its final post-trial challenge, and his long awaited payday was imminent. After accounting for taxes, Mackey was expecting to net around $700,000, his reward for the considerable effort expended over years on the case, not to mention the inherent risk involved in taking the case on a contingent fee basis.

Mackey was also jubilant about the mind-boggling rise in the stock market during the 1990s. He had seen his portfolio grow quite nicely, to say the least. Accustomed to average double-digit annual gains and seeing the stock market hit new highs practically on a daily basis, Mackey was looking forward to putting his lump sum payment to work ASAP.

While the timing of his contingent fee payment and the level of the stock market just before the tech bubble burst were coincidental, the elements of Mackey's story are actually fairly commonplace. Many attorneys receive unusually large payments at various times in their professional careers, whether from contingent fee payments, deal closings, inheritances, or even a pension plan rollover at retirement. And while the rise and fall of the stock market in the late 1990s and early 2000s was exceptional in its magnitude, it was not unprecedented, and markets will continue to exhibit considerable volatility, providing ample reward and risk. With this in mind, what should Mackey ' or any other investor ' do when they receive a lump sum payment?

Planning and Perspective

While the receipt of a lump sum may be unique in the financial life of the recipient, the award should never be invested on an ad hoc, stand-alone basis. Instead, it should always be invested pursuant to a well conceived financial and investment plan. That plan must be firmly grounded in the investor's short-term and long-term financial goals, such as funding a home remodel or second home, financing childrens' college educations, and insuring the investor's own ultimate retirement security. In addition, the new deposit must be invested in the context of the investor's other investments to make sure that the overall portfolio maintains the proper balance and diversification.

Having a comprehensive long-term plan helps investors avoid favoring the hot investment of the moment, an option that so frequently disappoints and represents a setback in the path towards reaching one's financial goals.

Mackey's situation was similar to that of many others, in that he had multiple objectives in his financial plans. While part of his lump sum was earmarked for immediate expenses, a portion was added to his kids' college savings accounts and most was dedicated to his long-term retirement planning. Accordingly, the bulk of it was invested for long-term capital appreciation. A portion was used to make the annual contribution to his retirement plan, and the larger balance was added to the investment account containing his other after-tax savings.

Balance, Diversification and Risk Management

Much has been written about the need to adequately diversify one's portfolio, but most investors simply don't do a sufficient job. By the late 90s in particular, the market's outsized rewards for portfolios concentrated in tech stocks and other growth companies caused many investors to lose sight of the merits of diversification. Sadly, the results for many of them were disastrous.

The foundation of a solid investment plan is a portfolio that strikes an optimal balance between seeking attractive returns and effectively managing risk. The key to success is nearly always found in the overall asset allocation, first in matching the portfolio's asset mix to the investor's unique goals of capital appreciation, income (if appropriate) and capital preservation. At a minimum, the portfolio should have broad diversification within the traditional asset classes of stocks and bonds, again depending on the investor's objectives and risk tolerance. Investors should be global in their reach, embracing foreign established and emerging markets and seeking exposure to smaller and mid-size companies here and abroad to complement the traditional blue chip fare.

While most investors stop there, more can be achieved by combining “alternative assets” in a portfolio of traditional securities. There are numerous asset classes and strategies that have been attractive to own on a stand-alone basis, but tend not to move in close correlation with the stock or bond markets. These alternative assets include real estate (both direct ownership and through real estate securities), high-yield bonds, commodities, hedge funds, and private equity. Incorporating some of these strategies into a portfolio that contains stocks and bonds should help the investor improve the portfolio's reward potential, lower its risk and volatility, or as is often the case, do both.

The importance of adding alternative assets to a traditional stock and bond portfolio cannot be overemphasized. Indeed, the Nobel Prize in Economics was awarded many years ago to a group of academic economists who had demonstrated quite convincingly that combining portfolio elements that do not move in sync with one another could meaningfully improve the overall portfolio's return and/or risk exposure.

Another risk management strategy for investing a lump sum is “dollar cost averaging.” Rather than place a large, perhaps one-time payoff into the volatile financial markets all at once, the funds should be put to work over a longer period, in regular intervals over several months or longer. Through this strategy, the investor can enter the market at different times and valuations, partly reducing the risk of putting it all to work just before a potential major downturn. By dollar cost averaging, if the markets turn down after investments commence, the investor will buy more shares at a lower price, just as they will buy fewer shares when markets are rising. The average cost of purchases made over periods of volatility will be lower than the cost of shares bought during the times of higher valuations. Finally, an additional way to reduce this risk on a shorter-term basis is to begin with a more conservative investment plan, in terms of the overall asset mix, and revise it at some point in the future.

In early 2000, Mackey was understandably excited about investing more in tech stocks. After all, the opportunities presented by the Internet in the new world order seemed unlimited, and available for savvy investors to exploit. But as with every previous revolutionary economic transformation, after a manic period in which virtually everybody profited, the shakeout left a few winners and many more losers as the technologies evolved and matured. Mackey (reluctantly) accepted the advice to combine investing in this growth potential with significant commitments to other sectors, asset classes, and strategies. Fortunately, over time his more broadly diversified portfolio helped him preserve and grow his hard-earned lump sum, as many segments of the financial markets escaped the worst fallout when the markets turned south. Some even profited nicely during the long and deep bear market.

Costs and Taxes

Investing is never a cost-free exercise, and a sound investment plan pays close attention to transaction costs and advisory fees. This can make a huge difference over long periods of time, and a vigilant investor will come out ahead by avoiding unreasonably high investment expenses.

For most individual investors, the biggest investment cost turns out to be taxes. Investors should seek to delay the realization of tax liability as long as possible, through low turnover and longer holding periods. That way, the ultimate tax liability will be tilted more towards the lower rates of long-term capital gains. Qualified dividend income also now enjoys that preferential tax rate.

Employed investors like Mackey may also be able to shelter some of their lump-sum payments into qualified retirement plans, like profit sharing or defined benefit plans. This will lower their tax liability on the amounts they receive as earned income and place some of their assets into accounts that are tax-sheltered while they are growing.

The period from February 2000 to the fall of 2005 has been a tumultuous time for the financial markets, marked by extreme highs and lows. Yet having a sound investment strategy, grounded in strategic diversification, risk management, and an attention to costs, helped Don Mackey navigate a steadier course through the turbulent waters. The lump sum payment that he received five years ago is still hard at work, worth considerably more now than when he started at the market peak in 2000. Just as Mackey worked zealously to win and defend a favorable award for his client, by having a comprehensive and effective approach to investing, his portfolio has earned solid returns while effectively managing risk and helping him make great strides on the road to achieving his financial objectives.