Entrepreneurship continues to flourish, regardless of the ebbs and flows in markets. Our 2018 Billionaires Insights report found that 199 entrepreneurs had become billionaires in the prior year. China alone minted around two billionaires a week, a trend that has been supported by the growth of e-commerce and technology businesses.
But wealth creation also comes with investment dilemmas, especially when entrepreneurs sell their businesses. When markets are uncertain, it can be difficult to know when to put the resulting cash windfall to work. One thing is for sure: staying in cash over the long term is almost certain to be harmful to your wealth.
In a new report we look at some strategies investors with cash windfalls can deploy to help achieve their long-term goals.
- Going straight into the market: This can feel uncomfortable for many investors, given the risk of investing near a market peak. But financial theory suggests that putting a deposit to work straight away is often the best option, since risk assets typically trend higher. Looking back to data since 1945, the S&P 500 has traded within 5% of a record high 60% of the time, and only 12% of the time more than 20% below its last all-time high. So the cost of waiting for a pullback, which can take months or even years to materialize, can be high.
- Phasing in: Of course, with large deposits the potential cost of bad market timing is greater. Since World War II it has taken an equity-only portfolio just over two years (26 months) on average to recover from a trough back to a prior market high. This would be a distressing wait for an investor who has mistimed a large windfall investment. The potential for such an eventuality would be mitigated by investing directly in government bonds – which are less volatile – and phasing into riskier assets. This is known as "dollar cost averaging." We believe the best strategy is to establish a set schedule, and to accelerate each phase-in tranche if there is a market dip of at least 5%.
- Put selling: A put-writing strategy enables investors to earn a premium by giving others the right to sell them a security or exchange-traded fund (ETF) at an agreed-upon price – typically a discount to the current market price. If the market does not fall, the option expires worthless, and the put-writer keeps the premium. If the market falls, the put-writer – who had been intending to increase exposure to equities anyway – ends up taking delivery of the stock. While this strategy is not without its drawbacks, it can mitigate the drag on returns as an investor gradually enters the market.
- Buying call options: The biggest risk of any phase-in strategy is "opportunity cost," where markets rally sharply, resulting in forgone gains when the investor eventually buys at a higher price. Call options are one way to help defray this opportunity cost.
- Using structured investments: As an alternative to directly purchasing option strategies or other derivatives, some investors may be willing to commit their cash fully upfront in exchange for a structured investment that provides some combination of these strategies' characteristics. For example, some structured investments limit upside participation in an underlying index, in exchange for downside protection, a fixed coupon payment until maturity or other features to adjust the likely distribution of returns.
So recipients of a large lump sum should consider a range of options before putting their money to work, and avoid just sitting on the sidelines in expectation of a market correction. For more detail on this subject, see our latest thoughts on how should investors deal with lump sums.
Instead of sitting on a large lump sum, there’s a range of options to explore before putting your money to work. Going straight into the market has historically been most fruitful, but alternative phasing in, selling puts, buying call options or structured investments are important strategies to consider instead of sitting on the sidelines.