The best way to invest an inheritance and protect your newfound wealth

Receiving a lump sum inheritance can be life-changing. But when it comes to deciding what you should do with a sudden windfall it is easy to feel overwhelmed by the range of options at your fingertips. 

Undoubtedly one of the worst things you could do – besides spending it all at once in a mad frenzy – is put the money in your current account. This will leave your inheritance at the mercy of inflation. If inflation is on average 2 per cent, then in terms of purchasing power a £100,000 lump sum would be worth just £50,000 in 25 years. 

Taking a proactive approach to growing your inheritance is crucial. Here, Telegraph Money tells you what you need to know about investing to get the most out of your newfound wealth. 

First things first 

Make sure you have a rainy day fund

This should be a sum of money to cover an unexpected expense. It is generally advised that you keep enough for three to six months’ expenditure. 

However, this isn’t an excuse to leave thousands of pounds languishing in your current account. Put the money in a savings account paying a competitive rate. 

Pay off your debts 

This includes overdrafts, credit cards and loans. The high interest rate on these debts will probably eat your wealth faster than the rate of your investment return will grow it. 

Does this mean you should also pay off your mortgage or, if you have it, your student debt? That depends.

Emma Watson of the wealth manager Rathbones said clearing student debt can be a sensible thing to do, especially if your loan has a relatively high interest rate (like those taken out since 2012). Workers on “Plan 2” loans will be charged a maximum interest rate of 6.9 per cent. The debt is repaid at a rate of 9 per cent on everything over the earnings threshold of £27,295. 

However, because the monthly repayments are based on your earnings, the cost is probably only worth it for very high earners. Bear in mind the debt is wiped after 30 years regardless.

With mortgage rates going up, Ms Watson said the argument for paying off your mortgage first is stronger than it has been in the past. 

“However, the principle of look before you leap applies as, if your mortgage is on a fixed term, there may be penalties applying to free yourself from it,” she said. 

Protect yourself

Promises of sky-high returns are telltale signs of an investment scam. Only put your money with a provider regulated by the Financial Conduct Authority. 

Be wary of saving more than £85,000 with one institution – only sums up to this limit are protected under the Financial Services Compensation Scheme, in the unlikely event the company goes bust. 

Should I invest it all in one go or in smaller increments? 

Another thing to consider is whether you should invest the sum all at once, or in dribs and drabs. 

You may have heard that drip-feeding the cash into investments will help to avoid the impact of market peaks and troughs. 

James Norton of the investment platform Vanguard said: “No one wants to accidentally buy at the top of the market, so spreading your investments over time can provide some protection against the possibility of the market dropping sharply, shortly after the money is invested.”

However, most of the time, drip-feeding will lead to lower returns. This is because markets tend to go up more often than they go down. 

“This means you’re likely to buy more units when prices are increasing rather than declining, which would be an inefficient strategy,” Mr Norton said. 

Drip-feeding will usually also require you to hold a large amount of cash for longer. 

“Cash tends to earn a low return and will be a drag on your portfolio’s overall return. Even now with higher rates achievable on cash, the return is substantially below inflation, and the return a long-term investor would hope to achieve,” Mr Norton said. 

Ultimately, investing a lump sum all at once will likely lead to better returns. 

However, if you cannot afford to take much risk or are fearful of a market downturn, then you may want the peace of mind that drip-feeding can offer. 

This leads us on to our next question – deciding your time frame and goal. 

Deciding on a goal

Before you invest the money, you need to decide on a financial goal. Common ones include purchasing a property, paying a child’s school fees or university fees, or saving for retirement. 

You should be prepared to part with the money for the long-term. Five years is unlikely to give you enough time to ride out the market dips. So younger inheritors hoping to buy a house may want to consider keeping the money in a savings account with a good rate, such as these, rather than putting it in the stock market.

Whatever your goal, it can probably be separated into one of two groups: growing a nest egg or investing for income.

Growing a nest egg

The longer your time horizon, the more volatility you can afford. This justifies a higher allocation towards stocks and shares. 

Historically, equities have provided the best long term returns. 

This does not mean you have to get that exposure directly through stocks and shares – in fact if you only have a small inheritance, this is probably too risky. 

Lisa Caplan of the investment management firm Charles Stanley said: “If you are an inexperienced investor, use most to invest in one or two ready-made funds, and keep some in cash. It is difficult to get a well-spread portfolio of shares with £20,000; give some thought to trackers as they are low cost, but make sure they are underpinned by real assets.” 

She added: “If you’re operating in the hundreds of thousands, you would be able to get a good spread of investment across individual shares; however, diversification remains key.”

Diversification means investing across a range of different sectors, geographies and asset classes to lower your overall risk. 

Index trackers – which mirror an index like the FTSE 100 – have in-built diversification. They are also cheap, charging on average 0.11 per cent. But with these investments you will never be able to beat the market. So it is recommended that you access large markets via an index tracker, and then get more niche exposure through actively managed funds.

Rob Burgeman, of wealth manager RBC Brewin Dolphin, says: “An investment in the Fidelity Index World Fund is a very cost effective way of getting exposure to global stock markets and is available at an annual charge of just 0.12 per cent. 

“Partnering with a fund like Fundsmith Equity Fund, a more active fund that prioritises long-term growth and avoids investment in economically cyclical sectors like banks and commodities – albeit at a higher cost of 0.94 per cent – offers what I would hope is the best of active and passive returns.”

You could also want to consider investing in property. The returns could overshoot those made from equities once rent and capital gains are factored in. However, tax changes have made buy-to-let less lucrative in recent years, so proceed with caution here. 

If you are saving for retirement, Ms Watson said you should consider using the inheritance to boost your pension contributions. 

“Most people don’t fully utilise their annual allowance for pension contributions and unused allowances from the previous three years could potentially be used too, so it’s worth checking on this. 

“Tax relief is available on personal contributions made up to your earnings, which could potentially increase your contribution by 20 per cent or reduce your tax bill if you are a higher or additional rate taxpayer. If you have a non-working spouse you can also invest a total of £2,880 pa (topped up to £3,600 by the treasury) in a pension, which can help boost retirement income.” 

Investing for income 

If you are coming up for retirement and need the investment to provide some income, then you should probably reduce your risk. 

This does not necessarily mean cutting your equity exposure – it is more a case of adding low-risk assets, Mr Burgeman said: “Bonds – normally issued by governments and companies – offer fixed returns, but not normally much in the way of capital growth. 

“Jupiter Strategic Bond Fund has the ability to negotiate the sometimes tricky waters of bond markets while, at the same time offering a gross yield of around 5 per cent. At the same time, this could be partnered with a fund such as 3i infrastructure Investment. 

“As its name suggests this invests in toll roads, bridges, tunnels as well as healthcare and educational establishments and offers a yield of around 3.5 per cent. It is more volatile than bonds, but much less than equities.”

Mr Burgeman added that the more income you want from the investment, the greater emphasis you should place on bonds and alternative investments rather than equities. 

“Bear in mind, though, that the equity element will do the heavy lifting for capital growth, so having no exposure here is probably not suitable for any but the oldest or most risk averse clients.  Even modest rates of inflation – and inflation is, at the moment, far from modest, can quickly erode the value of money in real, inflation adjusted terms.”