How to invest a lump sum

Things to consider before you start investing

There are a number of things to put in place and think about before you start investing. 

First, put aside some ‘rainy day’ money for emergencies, ideally three to six months’ salary in cash. This will ensure that if something happens and you need to access your money, you can do so easily and will not have to sell your investments at a potentially disadvantageous time, such as after a fall in their value.

Second, focus on clearing debts, tackling the most expensive ones first. While it is important to have rainy day savings, it is not normally a good idea to prioritise additional savings or investing over reducing debts, because debts usually cost more in interest than savings earn, as well as costing more than the potential returns that are on offer from investing.

Another test to pass is to be committed to investing for at least five years, as over the short term the stock market can be unforgiving. This timeframe is viewed as the minimum holding period when investing in a fund or investment trust, which are managed by a professional investor called a fund manager.

You may also consider overpaying your mortgage ahead of investing if you’ve received a windfall. 
In addition, you might also prioritise topping up your pension – such as through a self-invested personal pension (SIPP) – before putting more into a stocks and shares ISA or a general investment account. 

The importance of understanding your investing needs and goals

Next, you need to think about why you are investing and what you would like to achieve (your aims and objectives). You must also understand your tolerance to risk rather than appetite for reward. Every investor must consider the potential downsides before getting started.

When it comes to risk, your age is a factor. Those who are younger have much more time to ride out stock market volatility than those who are close to retirement. Your investment goals are also important. For instance, someone in their 20s or 30s who is investing towards their retirement will have a different risk mindset compared to if they were investing for a house deposit, due to the former being a much longer time horizon. 

With more time on your side, you have greater flexibility (providing you are comfortable doing so) of choosing investments that are more adventurous. 
Regardless of your risk appetite, you should look to invest tax efficiently by utilising ISA and pension wrappers, including a self-investment personal pension (SIPP). 

It is also important to consider how much time you're prepared to spend on your investments. Investments such as passively managed index funds or exchange-traded funds (ETFs) offer you instant diversification and the security that they're performing as well as the market - for better or worse.

Other investments, such as investing directly in companies or outsourcing the stock picking to a professional fund manager, require paying regular attention to how they're performing, and then revising your portfolio when necessary.

Popular investment options when investing a lump sum 

Creating a well-diversified portfolio will help you manage risk. To create this diversification and build a portfolio that suits your risk appetite, spread your money across different asset classes, including shares, bonds, and property. 

For funds it is important that you invest in strategies that are sufficiently different from one another. For example, if you invest in half-a-dozen UK funds you could end up owning hundreds of companies and unwittingly replicating the performance of the stock market.  

How you design your portfolio will depend on your appetite for risk. For example, if you are comfortable taking risk and have a reasonably long timeframe or you're not dependent on the money, you could hold most of the portfolio in funds that buy shares. 

Conversely, if you’re more cautious it is worth considering having a portion of the portfolio in bond funds, which are lower risk than shares. This strategy has historically given investors a smoother ride. One approach is the 60/40 portfolio model, holding 60% in shares and 40% in bonds. 

You also need to think about whether you are investing for growth, income, or both. This will help you focus on the right types of funds for your needs and goals. 

Lump sum versus regular investing 

The reliable way for investors to reduce the risk that they enter the market at a disadvantageous time, is to drip-feed money into an investment on a monthly basis. A regular plan, involving investing at the start of every month, for example, does away with the risk that you might put all your cash into the market just before a market fall. 

Similar to household bills, you can set up a direct debit to take a specified amount from your bank account every month. Regular investing is free on the interactive investor platform. 

This strategy benefits from what is known as pound-cost averaging. When stock markets fall, the regular investment purchases more shares or fund units. Conversely, when stock markets rise, fewer shares and fund units are bought.

Lump sum investing can be more profitable 

Generally speaking, when markets are buoyant, lump sum investing wins out over investing regularly on a monthly basis. 

Remember, though, that while investing a lump sum can in some situations be more profitable, it is higher risk than drip-feeding your money into the market.  

How to minimise tax when investing a lump sum 

Tax-efficient ways of investing – such as stocks and shares ISA (ISA) and/or a self-invested personal pension (SIPP), should be the first port of call, as they protect any gains you might make and income you receive from the taxman.

Under current rules you can set aside up to £20,000 each tax year into an ISA and a maximum of £60,000 in a SIPP, as long as you don't pay in more than your taxable earnings. The tax year runs until 5 April.

With a general investment account, if you go above the respective thresholds there’s capital gains tax, or CGT, to pay, while dividend income is also taxed.

Best practice when investing a lump sum 

Diversify your portfolio 

Diversification is achieved through mixing a range of stock market investments with other investment types, primarily bonds and property. 

The theory is that different types of investments are unlikely to all outperform or underperform at the same time, which reduces the volatility of your overall portfolio. 

Monitor and review your portfolio regularly

Reviewing a portfolio a couple of times a year is a useful exercise to stop complacency creeping in. If investments have been underperforming find out why, and then consider taking action. For winning investments, it is also worth doing a review, and as part of that consider taking some profits. It is also worth reviewing winning investments, and perhaps consider taking some profits.   

In the case of funds and investment trusts a potential warning sign for the future is the departure of a fund manager as this may signal a change in direction for the fund. 

Keep an eye on costs and fees 

Regardless of how you choose to invest – whether through funds, investment trusts, exchanged-traded funds (ETFs) or individual shares – a certain desired level of investment return over a specific time period cannot be guaranteed in advance.

However, one thing that investors can control is costs. When it comes to actively-managed funds - those with a professional fund manager(s) making the decisions - a yearly charge of 0.75% to 1% is typical. For passive funds – index funds and ETFs – fees can be 0.1% or less for tracking the up and down fortunes of developed markets, such as the FTSE All Share and S&P 500. 

Therefore, active funds need to justify their higher fees with market-beating performance.