How to invest a lump sum ?

I’ve just had a windfall gain land in my bank account.

What is a windfall gain?

What do I mean by a windfall? I think of it has a material, lumpy sum of money that arrived somewhat unexpectedly.  Many of us can expected windfalls at some point in our lives, but they remain unexpected in amount and timing. Some are happy events – winning a lottery.  Probably more are the silver lining on a sad cloud – such as inheritance, compensation payments, etc.

This particular windfall is because a company that I ‘angel invested’ in a few years ago has just been acquired.  The company has done well and my shares have grown in value a lot – over 10-fold.  I’ve been forced, by the investment transaction, to sell my shares.  Thanks to the generous UK tax breaks for angel investors, this large gain is subsidised by the taxman.  My gain is almost completely tax free.

These shares were in a private UK company, so they were extremely illiquid.  I don’t treat such investments as part of my tracked investment portfolio – I treat such ‘angel’ investments as ‘flushing money down the drain’ and thus truly consider any gains I eventually receive as money from heaven.   I usually can’t choose to sell, can’t choose what price to take, and often have very little information about the business – in this case, a lot less information than the acquirer. Indeed in this particular case a portion of my money has been retained in an escrow account for 12 months pending ‘warranty claims’ by the buyer, so I don’t even have all my money yet.

In any case, in this particular situation I am in the happy position of a six figure sum landing serendipitously in my bank account.  This sum isn’t enough to change my life – in fact it is a smaller sum than the decrease in my portfolio’s value in the first three months of 2018 – but it is a much larger amount of cash than I normally have at hand.  What to do with such a sum?

The perils of good fortune

Academics will tell you we are more likely to spend windfalls than other equivalent sums.  I remember a long time ago, when I first made some serious money and had a life-changing windfall to celebrate, how a friend of mine was pushing me to buy an Aston Martin.  His psychology was, and is, very different from mine. But even I have found over the years that if you aren’t careful some of your ‘easy come’ money does ‘easily go’, and you can forget some of your (e.g. tax) liabilities, and the next thing you know your good fortune has become a painful cash shortage.

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How many ISA millionaires are there?

A new UK tax year has just begun, and with it a new annual ISA allowance of £20k each. ISAs are an amazing tax-break for investors who are UK taxpayers.  I love them, and have a goal to get my ISA portfolio to £1m+.  I’ve been posting updates annually about this (e.g. here, and the one before).

Why is being an ISA millionaire cool?  The £1m mark is just an arbitrary number, after all – unlike UK pensions which are capped for most of us at £1m. A million quid maintains an allure, even after the ravages of inflation.  And sensibly invested it should produce an annual income of £35k-£40k, tax free – whereas a £1m pension’s income is taxable, if it is taken.

Since the government lifted the allowance to £20k per person a few years ago (an un-noticed marriage tax break for wealthy, i.e. mainly Tory, voters), even ignorant ultra-conservative investors using just Cash ISAs can become ISA millionaire-couples in ‘only’ 25 years. But their £million won’t be worth as much as it would have been when they started, and they won’t benefit from tax-free compounding over the 25 years.

£20k here, £20k there and, pretty soon, you’re talking real money

ISAs in their current form started in 1999, when they replaced other tax-friendly savings arrangements such as PEPS, TESSAs.

Any single person who’d topped up their ISA to the maximum every year since 1999 would have, if they have just topped up their 2018/19 ISA, invested £206k in their ISA.  If this money was invested in a low-cost FTSE All Share index tracker, with no withdrawals, it would today be worth around £380k. A married couple who have doubled up the whole way will be sitting on a combined ISA pot of double this, which is over $1m.  So, in dollars, a pair of wealthy ISA-loving investors would be ISA millionaires if they have achieved market average returns over the last 19 years.

Being an individual ISA millionaire in pounds is much harder.  But if you were saving hard using the PEPs/TESSAs that preceded ISAs, you had a crucial starting advantage.  This is one of the ways that the most famous UK ISA millionaire, Lord (John) Lee did it. But if, once ISAs came along, you achieved only average market returns, you’d have had to begun your ISA journey with £187k of savings.

How could people have begun their ISA journey in 1999 with £187k savings?  The Capital PEP, which would have been the best vehicle to have used, started in 1987 with an annual allowance of £2.4k.  By 1990 it had risen to £6k.  But this means the most you could have invested before 1999 was £64.2k.

What were the chances of turning £64k into £187k in 12 years? As it turns out, the chances were very good.  The 1991-95 boom saw the FTSE All Share return over 20% per year in four of the five years.  So an ‘all in’ PEP investor, achieving average returns, would have had £159k in their ISA account on day 1.  Maintaining average returns and continuing to be ‘all in’ would have got them to around £850k today.

In fact, an ‘all in’ investor like John Lee would have only needed to outperform the market by 1% per year in order to cross the £1m threshold, which they would have done in the last 12 months.  Outperforming the market by 1% per year is no mean feat, but there are certainly countless UK investors who have done it. Of course, in the recent Brexit-y era, the more of your investments were outside the UK the more you’ll have beaten the UK market.

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Loans: what can possibly go wrong?

Just over a year ago, an unusual opportunity arose.  A friend asked if I might be up for lending his small property development company some money.  I ended up going ahead with it.  What happened? What lessons can I learn?  I’ll share the former, hoping my readers can help me with the latter.

Who was the borrower?

The loan was to a small private company doing real estate development. Basically they buy buildings in London where they believe they can get planning permission to increase the number of dwellings; they then maximise the planning potential of the buildings, do the work themselves, and sell on the units. They’ve got a few years’ successful track record.

I have known the three principals for over twenty years; one of them is a very close friend of mine, admittedly one who has radically different approaches to FIRE/money/investing.

What were the terms?

I reached agreement as follows: Read the rest of this entry »