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How to Invest an Inheritance

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A friend recently asked for some advice on stocks for investing some money he inherited. At first I was hesitant; bad advice is easy to give, and good friends are hard to find. But his plan was to meet with a financial planner, and he just wanted to go in with a few strawman ideas. Kibitzing without responsibility: Now that's something I can do.

A little background
My friend, we'll call him Jack, is within a couple years of retiring. He has a military pension and a 401(k) plan in addition to some personal savings; his kids are grown, and his only major debt is a mortgage. He has told me he has more risk in his 401(k) than he's comfortable with, with a particularly heavy allocation to an international stock fund, and is planning to make some adjustments. The inheritance certainly isn't big enough for him buy a beach house in Malibu and put a Bentley in the garage, but it's enough to make him think he might retire sooner rather than later.

Two key points that jump out are that Jack's current portfolio is riskier than he's comfortable with, and that Jack has a pension covering a good chunk of his retirement income needs. That gives him some flexibility to take a little more portfolio risk than if he didn't have the pension.

Goals and risk
A good first step in any investing decision is to ask two questions: 

  1. What do you want this money to do?
  2. How much risk are you willing and able to take? 

In this case, the goal is easy: start providing retirement income in the near future.

The risk question is a little trickier. Jack's inflation-protected pension gives him a steady income, but his overall 401(k) portfolio already has more volatility than he likes. Assuming that Jack has enough money to get by in the long run with more conservative investments, I think he should invest his inheritance in a way that will reduce the risk and volatility of his overall portfolio.

With retirement imminent, keeping a decent slug of money in cash and short-term investments makes a lot of sense. Those aren't earning much these days, but they'll help smooth out some of the volatility.

For longer-term funds, though, a reasonable split between stocks and bonds will help balance current income generation against the need for future growth. Dividend-paying stocks of companies with strong balance sheets and whose earnings comfortably cover their dividends would make a valuable component of Jack's proposed portfolio, as they address the goal of providing income without unduly raising the portfolio's risk level.

Whether to use mutual funds, ETFs or individual stocks is largely a personal decision. Have the interest and time to do the research, track the stocks, and occasionally dig in to see if one of the holdings should be swapped out? Go for individual stocks. If spending time with spreadsheets, 10-Qs, and stock research doesn't sound like fun, pick a good fund manager, index fund, or broad market ETF. In this case, an ETF focused on dividend paying stocks like best dividend recommendation Vanguard Dividend Appreciation (NYSE: VIG  ) or Wisdom Tree Total Dividend (NYSE: DTD  ) would be a good fit.

Some stock ideas
But if you don't want to settle for an ETF, what stocks make sense? To help generate some stock ideas, I used the stock screener at Motley Fool CAPS with the following parameters:

  • Market Capitalization > $2.5 billion
  • CAPS rating of four or five stars
  • Positive earnings and P/E ratio less than 16
  • Long-term debt-to-equity less than 1.0
  • Dividend yield greater than 3%
  • Positive earnings growth over the past three years

The screen returned 38 hits, including those listed below:

Company Name

Current Dividend Yield

Price-to-Earnings (TTM)

EPS Growth Rate
(last 3 years)

Bristol-Myers Squibb (NYSE: BMY  )

5%

14.7

27.7%

ConAgra Foods

3.2%

13.8

10.2%

Consolidated Edison

5.3%

13.6

0.2%

Exelon

5.2%

9.8

9.6%

Johnson & Johnson (NYSE: JNJ  )

3.4%

12.4

9%

Kraft Foods (NYSE: KFT  )

3.9%

10.9

10.6%

Merck (NYSE: MRK  )

4.3%

6.9

44.4%

Sysco

3.2%

15.8

6%

Procter & Gamble (NYSE: PG  )

3.2%

14.6

12%

Source: Motley Fool CAPS. As of June 21.

Stocks from health care and consumer goods are heavily represented in the list. Bristol-Myers, Merck, and J&J benefit from the fact that no matter what the economy does, people need prescription drugs and over-the-counter medical products. Similarly, the first money people have to spend month after month goes to Kraft, P&G, and other makers of consumer staples.

These industries tend to be steady regardless of the economy, and steady business means good odds the dividend payout will continue in good times and bad. The dividend yields are all at or above the current yield on a 10-year Treasury, and valuations are reasonable. Moreover, with the exception of Bristol-Myers, these companies have payout ratios below 75%, and earnings growth is also a good sign that the company will be able to increase dividends in the future.

Screen results should not be taken as a recommendation, but as a starting point for more research. And, more work is needed to look for good candidates that may have missed a screen cutoff, like utilities that tend to have debt loads that would have been above the limits for this screen.

Takeaway
The first question you should ask before investing an unexpected windfall should be how an investment can help you reach your goals and fill gaps in your existing portfolio. By focusing on goals and concerns, you'll put yourself in the best position to make your investments stronger.

Related Foolishness:

Fool contributor Russ Krull owns shares of Sysco and Johnson & Johnson. Exelon and Sysco are Motley Fool Inside Value picks. Johnson & Johnson, Procter & Gamble, and Sysco are Motley Fool Income Investor picks. Motley Fool Options has recommended writing puts on Exelon and buying calls on Johnson & Johnson. The Fool owns shares of Procter & Gamble and Sysco. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.


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Russ Krull
rd80

Russ is a naval architect and retired Coast Guard officer with an interest in financial markets. He's been a contributing freelancer for The Motley Fool since 2009 and a CAPS player and blogger since 2007.

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