After a winner emerged for the $338 million Powerball jackpot, the losers were deflated. Who among us can pass up the opportunity to daydream about winning the lottery, despite the rotten odds? While most will never hit the big one, many are fortunate enough to receive a windfall every now and then, whether through an inheritance or the sale of a house or a good investment. What should you do if you are lucky enough to come into a sizeable sum?
If you do not have existing relationships with professionals, it's time to assemble your team. You need to interview estate attorneys, accountants and financial advisers. Amazingly, when I was an investment adviser, I actually had a client who won the lottery, and she did something incredibly clever in approaching potential professionals: when conducting her interviews, she held back the magnitude of the windfall amount until late in the meeting. "That way," she said, "I could tell what kind of person I would be dealing with -- in other words, do these people treat all of their clients with respect, or just the rich ones?"
Investor purists will note that this is just a variation on the age-old question: Should investors invest a lump sum or dollar-cost average? According to research from Vanguard, the answer is clear: two-thirds of the time, investing a windfall immediately yields better returns than putting smaller, fixed dollars to work at regular intervals.
The mutual fund giant analyzed returns from 1926 to 2011 and found that a lump sum portfolio comprised of 60 percent stocks and 40 percent bonds over rolling 10-year investment periods beat DCA by 2.3 percent. In other words, if you had invested $1 million all at once, it would have led to an average ending portfolio value of $2,450,264 after 10 years, versus DCA for the same portfolio, which would have been worth $2,395,824.
The $54,440 differential may be large enough for you to go for the lump sum without looking back. But what if the lump sum decision were to occur at the beginning of a terrible 10-year period for stocks? While lump sum may beat DCA two-thirds of the time, DCA still returns more one-third of the time.
If you are the kind of investor who is less concerned with the probability of earning and more worried about losing a big chunk of money immediately, you may want to stick to DCA. Vanguard's study notes "risk-averse investors may be less concerned about averages than they are about worst-case scenarios, as well as the potential feelings of regret that would occur if a lump-sum investment were made immediately prior to a market decline."
And of course, there's the risk that anyone who receives a windfall could blow the money before it ever gets invested. For those folks, it may be advisable to work with the adviser and explore an immediate annuity issued by a highly rated insurance company. When an investor purchases an annuity, she trades a lump sum of money for a fixed stream of payout options (income for life, income for a certain period of time or lump sum), which are guaranteed by the insurance company.
Even if you are not the type of person who would plow through a windfall, you may still want to consider an immediate annuity. The rationale is that you may feel more comfortable trading the potential upside return of your portfolio for the comfort of a lower, guaranteed stream of income.
Getting back to the most recent lottery example, the winner had to weigh whether to take the lump sum after-tax jackpot of $152 million, versus giving up access to the money and receiving an annuity comprised of 30 annual payments, which increase over time. The starting amount would be just shy of $4 million after taxes, and the last payment would be about $12 million. Oh, to have that dilemma!
(Jill Schlesinger, CFP, is the Editor-at-Large for http://www.CBSMoneyWatch.com. She covers the economy, markets, investing or anything else with a dollar sign on her podcast and blog, Jill on Money, as well as on television and radio. She welcomes comments and questions at firstname.lastname@example.org.)