Section IV - Lesson 8
Dealing With Lump Sums (Part I)
In this lesson and the next, we are going to look at various ways to
defuse the potential danger of investing a lump sum amount into your existing
investment program. The solution is usually to find a way to convert the lump
sum into a number of smaller monthly payments so as to avoid bad market timing.
First look to any debt you may have where you are paying more than 10% interest. Let’s say you have $24,000 in credit card debt at an 18% interest rate. If you’ve been making minimum payments of 2% per month, you’ve been paying $480 each month, and these payments are already in your budget.
If you came into an inheritance, let's say, of $100,000, why not take $24,000 of your inheritance and pay this debt off in full, while at the same time increasing the monthly amount that you regularly direct to your regular investment account by the $480 that previously went for credit card payments?
What you’ve done is convert $24,000 of lump sum into 48 monthly payments to yourself of about $500 per month. You’ve eliminated interest payments at 18% per year on this amount for the next four years, and set the stage for this amount to earn 10.5% per year instead. At the end of 48 months you can reduce your automatic regular monthly payment by $500 if you want to, but who knows? You may be so used to it by then that you may just never get around to it.
What else could you do? Suppose you also have an auto loan at about 10% on which you’re paying $340 per month for the next 36 months. Paying off about $12,000 in full, removes this item from your budget and adds another $340 per month to your regular monthly payment to your investment account for the next three years. Even though 10% is not a troublesome interest rate, this move further helps you to convert your big lump sum to monthly payments.
You’ve now converted $36,000 of your lump sum, leaving $64,000 to worry about. If you invested $16,000 of this amount every quarter for the next four quarters, or $8000 every quarter for the next eight quarters, you will have neutralized the risks of investing this large lump sum. You will have defused a potential bomb!
In the following lesson (part II on the subject of lump sums), we’ll talk more about how to keep this money earning interest while you make your quarterly contributions. We don't want to let this money sit idle. We just don't want to expose it to timing risk.
Before moving on to part II, let’s first make the point that there are some lump sum purchases that are not a timing problem. This is when you’re moving a large sum of money from one diversified stock fund into another diversified stock fund, as you may well be doing when you roll 401(k) money into an IRA, either at retirement or when changing jobs.
This is when both funds are subject to the same market forces. This is to say that these funds will more or less move up or down in unison. Whether the market is “too high” on the day you make the switch, or whether the market is “too low” doesn’t really matter. You are simply moving money from one pocket to another, so to speak, because the funds are so similar. Just be sure not to let much time elapse between the day you sell the old and the day you buy the new.
Would the situation be the same if you were switching from one diversified stock fund to another in your regular money account rather than rolling your 401k account as described above? This is a trick question, of course, because tax consequences are involved in the case of your regular money account and this adds a whole new dimension to the switch.
Assume, for example, that you’ve been investing in a managed load-type stock fund for a number of years and own $25,000 worth of this fund. And suppose that after taking this course you decide that a low cost no-load S&P 500 Index fund would be a better place for this money, and you wonder whether or not to make a switch to this fund.
You’ll want to consider your tax situation. If you have a loss in your old fund, or you are more or less even, you’d do well to go ahead and make the switch to the better market index fund. The taxes won’t hurt you, and the fact that you are moving a lump sum of money won’t hurt you because both funds are diversified stock funds operating in response to the same market forces.
More typically, however, you’ll have a gain, and a favorable cost, in your old mutual fund and you’d be ill advised to sell it and suffer the tax consequences, even to move to a better fund. In this kind of situation, your better course of action is to leave the old fund alone, but direct all of your future money to the S&P 500 Index fund. You simply wind up with money in more than one mutual fund, but this is no big deal.
We'll continue this discussion of lump sums in the next lesson.
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