"I Just Inherited $700k. What to do Next?"

Susan writes in:

My husband and I, who are both around age 50, received a lovely gift from a family member: a $700,000 inheritance.

I am wondering how to build a Canadian dividend investing portfolio with such a lump sum? Specifically…

• Do we invest so much per month over the course of the next few years? If we do this, we would have money just sitting there as cash and not invested (opportunity cost?). 

• Is it a bad idea to put that amount of money into Canadian dividend stocks given that the TSX is at an all-time high?  

• Do we still invest in the “keeper” dividend companies (banks, railway, utilities) even though they are not close to the 52 week low or lower than average P/E? It seems to be more difficult to find good value in this market.

Our goal is to retire between ages 60 and 65. Our mortgage is paid. We have budgeted that in 10-15 years our existing real estate investments, pensions and RRSPs will cover all of our living expenses.

Our goal is to invest the $700,000 in Canadian dividend stocks using any unused room in our TFSAs and RRSPs. After 10 years, we could use dividend payments for any fun extras, like vacations or to purchase a camper van or help the kids.

Any other ideas or advice for us?

Thanks to Susan for writing in. These real-life examples are excellent because I know so many of you guys reading will be in a similar boat one day. It’s best to think about these things beforehand, just to avoid rash decisions.

Related: I have $600k. Can I retire?

If any of you have a situation you’d like my thoughts on, feel free to reply to any of the emails I send. I can’t guarantee I’ll write about it, but I’m always looking for newsletter ideas.

Let’s start with some more general thoughts about investing a lump sum all at once, and then take a closer look at how I’d put that inheritance to work if it were my own money.

Dollar cost averaging vs. lump sum

In a world where a lot of Canadian dividend payers are flirting with all-time highs, Susan is rightfully a little concerned about putting the entire $700,000 into some of our old favourites. I can certainly see her point, and tend to agree that the market is probably a little bit overvalued today.

I’m going to look at this from a couple different perspectives.

The first is from a more academic angle. The nerds and eggheads have done the work (after getting wedgies from their cooler colleagues), and they all pretty much agree. Historically, it’s been better to just invest the lump sum in one fell swoop. Since the market tends to grind higher over time, getting money into stocks as quickly as possible is usually the best outcome. It might not look like it in the short-term, but over the long-term it usually ends up just fine.

Getting those dollars into stocks quickly gives Susan and Mr. Susan (totally his name, I asked) another advantage. Those dividend cheques start arriving immediately. Since the goal of the portfolio is to provide dividend income, it makes little sense to delay contributions.

However, I realize that investor emotions play a role here. Susan is nervous about losing money here, and I don’t blame her. Short-term losses hurt a lot more when you’re investing an inheritance versus putting away 20% of your salary for a few months.

Allow me to present an option that should satisfy both the academics and those who might be a little nervous about stock valuations today. Susan can invest most of the money — say 70-80% worth — and then “hide” the rest in something like a short-term bond fund or money market ETF. Then she can move capital out of the ultra-safe option when the market inevitably sells off.

This helps protect a chunk of the inheritance, de-risks the portfolio, and provides income while she waits for the market to inevitably correct again. She would then establish rules for putting this cash into stocks — something that could look like this:

Susan’s strategy might look a little different, especially if she isn’t into margin. But the point still remains — you want to come up with such a plan before the market falls, or else you’re in danger of falling victim to your emotions. It’s really easy to come up with excuses when it seems like the whole world is going to hell.

New cash versus existing investments

By now, most of you know the way I like to choose new investments is something like this:

• I scour the market for unloved assets that

  • Generate lots of cash

  • Pay dividends

  • Are trading at multi-year valuation lows

  • That offer higher than their average dividend yield

• I then choose what I view to be the best investments from that pile

From there, I’m embracing a long-term approach. I’m happy to collect the dividends and hold the stock for decades as long as it continues to execute. I’m also happy to average up in the future if there’s a stumble again, and for the most part I avoid selling.

Related: How I decide to sell a stock

Part of the reason why I came up with this strategy is because I don’t buy as many stocks as I used to. I mostly just sit back, relax, and hold. At this point I’m just reinvesting a portion of my dividends, plus any new cash that comes into family members’ accounts I manage.

This creates a situation where I can be selective. And if I can’t find much to buy, I just let the cash build up for a little while. I like to have a decent amount of cash on hand for my upcoming expenses, anyway.

In a world where Canadian stocks are bumping up against all-time highs, Susan simply can’t find enough quality dividend stocks that are trading at a discount. Sure, there are a few — Cogeco, Canadian National Railway, and Sunlife come to mind — but concentrating in these names probably isn’t the best idea. Even if all three return to former glory and outperform from here on out. It’s just too many eggs in one basket.

So, in short, here’s what I’m saying. A lump sum needs to have slightly different rules than slowly putting capital to work over time. There’s an opportunity cost in waiting, and owning quality over the long-term is a good idea. If I were the recipient of a lump sum like Susan, I would put a big chunk of it to work immediately and then slowly invest the rest during selloffs.

What should the portfolio look like?

Let’s pivot over to the portfolio itself. What should it look like?

As always, we’ll work backwards and see what Susan wants from it. From her note, she says:

“Our goal is to invest the $700,000 in Canadian dividend stocks using any unused room in our TFSAs and RRSPs. After 10 years, we could use dividend payments for any fun extras, like vacations or to purchase a camper van or help the kids.”

The first step here is to max out TFSAs, followed by RRSPs. Both Susan and her husband should play around with the various online tax calculators to make sure they’re maximizing their tax savings with their RRSP contributions. It might make sense to do them over a number of years, for instance.

Since the goal is to use the dividend payments for fun, I would err a little more towards the high yield part of the market. You still want dividend growth, but we’ll make that a bit more of a secondary goal versus getting income today.

We also want a decent portion of the income to come from dividends, rather than distributions. This is to minimize the tax bill while giving Susan’s family a nice passive income stream. In addition, she mentioned that they own rental real estate, so that’s going to be taxed at the full rate.

The easy way for Susan and her husband to earn decent dividends is to choose an ETF. We’re not fans of any of the enhanced income or covered call ETFs around here (they cap your upside and return your capital in the form of dividends), so I won’t advocate those. Instead, I’ll keep it simple and say that one of the following would be a decent choice:

• Vanguard Canadian High Dividend Yield ETF (TSX:VDY)

• iShares S&P/TSX High Dividend Index ETF (TSX:XEI)

• BMO Dividend ETF (TSX:ZDV)

Each yields close to 4%, has some dividend growth, and come with fairly low management fees. They’re a decent choice for the hands-off investor. Susan can also recreate each ETF on her own by skimming the top 15 or 20 holdings.

What Nelly would do

Enough with the generalities. Here’s exactly what I would do if this were my money.

(To keep the narcs off my back, this is the part where I say this isn’t financial advice, you shouldn’t blindly copy me, blah blah blah. This is what I’d do, that doesn’t necessarily make it the right plan for Susan or for anyone else)

I’d take the $700k and immediately invest $550k of it. I’d leave $150k on the sidelines and put it to work in some cash-like equivalent earning around 3%. I’d then slowly put it to work over time during any periods of market chaos.

I would then invest the $550k with the following plan in mind:

• Earning $20k per year (4% dividend yield)

• With the income increasing by about 4-5% per year

• Reinvesting the dividends until I decided to start pulling the money out for fun

• With the cash cushion ready to be put to work when the market falls

Here’s a list of the stocks I would be interested in for such a portfolio. There is some emphasis on companies that I think are cheap today, but for the most part it is valuation agnostic. I want the best stocks in this portfolio, even if I think they’re a little expensive. I’ll then add a few REITs to bump up the overall yield. I would hold the REITs in either my TFSA or RRSP to maintain the tax efficiency of the entire portfolio.

Without further ado, here is it. A quick and dirty portfolio:

I would go with equal-weight positions, since I’ve found that my ability to pick favourites from a large list is basically akin to picking them at random.

Susan can make some adjustments depending on what her goals might be, but from her note I’d say this portfolio would be pretty close. Plus, it errs a little bit on the side of value. Many of these stocks are either cheaper than peers, beaten-up for some reason, or are such quality that I had to include them — even at higher valuations.

I’d then maintain a watchlist of the kinds of stocks I thought were a little too expensive for the list — like Fortis, Emera, National Bank, among others — and look at adding these to the portfolio during periods of weakness. Remember, I’ve kept about 20% of the inheritance aside for just such an occasion. And if that doesn’t happen for a year or two, this cash position will slowly get larger as interest does its thing.

One more thing

My investing strategy is virtually the same whether I’m putting small bits of capital to work or larger lump sums. I’m looking for solid Canadian dividend-paying stocks that will deliver passive income, grow their payouts over time, and ultimately deliver solid total returns.

If I were receiving a large inheritance like Susan did, I’d put most of it to work right away and hold a little bit aside — just in case I get unlucky and the market falls immediately after I invest.

Susan mentioned that their family’s retirement was already in great shape before getting this inheritance, so I’m going to suggest that they have fun with the dividends each year. Buy that camper van sooner than retirement. Take the kids for a nice vacation. Put in a putting green in the backyard. It’s great she’s doing the responsible thing with the gift, but money is meant to be spent. Have fun with the dividends, and let the principal grow slowly over time.

Want to weigh in on what Susan and her husband will do? Find me on the ol’ Tweeter app and let me know your thoughts. I’ll make sure she reads every one.