“How do I invest a lump sum I don’t need for the next 5-7 years?” is a question most often asked to us or other social media forums. The best way to eliminate this confusion is to rephrase the problem statement.
Better still, if one has a proper goal-based financial plan, the answer to this question will become self-evident. Unfortunately, when we tell this, many listeners or readers get irritated that we have given an irrelevant answer.
This reminds me of a media personality that I met a while ago. Throughout our interaction, he asked me to choose “this” or “that”. He would get frustrated if I said both or something else. The problem is that the person asking the question assumes the correct choices. It need not be. The same is the case here.
If all my short-term and long-term are well defined and I am investing for them, I have only three options if I end up with a sudden lump sum. (1) I divide the amount among my goals and be done with it, or (2) I will invest this separately because I have a new need or want, and (3) a combination of (1) and (2).
Option (1) is quite simple. You have already planned for your goals and are investing for them with a set asset allocation schedule (one that will achieve your desired corpus while lowering risks). The freefincal robo advisor tool automatically generates asset allocation schedules for all financial goals. This removes all the confusion and uncertainty of sudden lump sum cashflows.
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Now, if for (2), you need to be clear about when you need/want the money because that will determine the risk. Is it five years, or is it seven years? The more precise you are, the easier it will be to invest.
Investors are often so hurried to put their money into a product (suitable or not) that they forget basic common sense. Here are some thumb rules. For asset allocations with equity, the numbers represent the initial mix. The equity allocation should be reduced gradually well before the goal deadline.
- Need the money in 3 years: 100% fixed income, zero equity (experience and risk-awareness is irrelevant)
- Need the money in 5 years: 100% fixed income, zero equity (experienced and risk-aware investors can include a little bit – 5-10% – of equity)
- Need the money in 7 years: 100% fixed income, 5-10% equity (experienced and risk-aware investors can include a little bit more- 10%-25% of equity)
- Need the money in 10 years: 80% fixed income, 20-30%% equity (experienced and risk-aware investors can include a little bit more – 30%-40% of equity)
- Over 10 years, the equity allocation can be increased gradually, but it should not exceed 50-60%. Fixed income is crucial to the portfolio.
Do not let a bull run or a bear run in the recent past determine the asset allocation. Being conservative is essential. It’s better to be safe than sorry.
Where should we invest after this planning? For the equity part, choose a Sensex or Nifty index fund, a multi-asset fund (equity-oriented) or an aggressive hybrid fund. At the time of writing, passive options are not available for these hybrid funds. That may (hopefully) change by the time you read this.
For the debt part, new investors are better off with short-term debt funds like a liquid or money market fund for goals of up to 10 years. For long-term goals, a gilt fund, a conservative hybrid fund or a debt-oriented dynamic asset allocation can be considered for those who can take on some risk after appreciating what they are.