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The answer will depend on your particular circumstances and what you want to achieve with the money. It will also depend on how much time you want to take in deciding what to do and on the size of that lump sum relative to what other savings and investments you have already. Whether you have got the money from an inheritance, from saving up yourself or from the Lottery doesn't really matter. However, there are some basic principles to follow.
Pay Off Your Debts
If you have any high-interest debts such as bank loans or credit cards then use the money to pay these off first. The interest rates you typically pay on them are much higher than the return you can expect to get from investing your money.
Consider Paying Off Your Mortgage
This is a little more complex. The interest rate you pay on a mortgage is less than you can expect to pay on other debts. You may get a better return by investing the money, but there is no guarantee of this. Paying off the mortgage is something to seriously consider. You can free up what you used to spend on your monthly mortgage payments for other purposes. The more conservative you are as a person then the more attractive this option will be.
Don't Invest For Less Than 5 Years
If you have plans to spend this lump sum within 5 years, then you shouldn't really be considering investing it on the stock market. The returns from shares are volatile and it can take time for them to come through. Therefore you don't want to be in the situation whereby you're forced to take out your money in a rush. If you need the money within 5 years, consider a high-interest savings account instead.
Think About Tax
We're not keen on the 'T' word either. But the larger your lump sum the more you need to think about the tax consequences of your actions. For example, if you pass away with more than £250,000 in assets, your estate may be liable to inheritance tax. However, there are many steps you can take to mitigate this so that you can pass on more of your wealth. For example, you can make a will. Our Fool's Guide explains the basic concepts.
Take Your Time
Just because you have a large sum of money burning a hole in your pocket that doesn't mean you have to take the plunge straight away. It's much safer to drip the money into your investments over a number of months or even a couple of years. The main advantage of this approach is that you worry less about whether the stock market has hit a temporary peak. No one likes to invest a load of money and then see it fall by 10% in the next month. You can also protect your investments from taxation by using up several years' ISA allowance.
To make things simple let's look at two basic situations. First of all you want to make the best possible return from your investment so that you have a bigger pot to retire on, or to pass onto your children. Secondly, you want to use the lump sum to generate some income to live on.
Maximising Your Returns
This is a double-edged sword. If you want a higher return you have to accept higher risks. In practice this means that although on average you can expect to get a higher return, the possible range of returns will be much larger than with a low-risk approach. There is a chance that you could lose money.
The basic default option for investing is to invest in the whole stock market by buying a product called an index tracker. This is also the cheapest way to invest. Research studies have shown that index trackers have beaten three-quarters of managed funds over five years, and they do even better over longer periods. So if you want a simple, no-nonsense, one-time decision then index trackers make sense. You can find more about them, and how to get one, in our ISA Centre.
If you want to shoot a bit higher than the market average you will need to take on additional risk by buying a managed fund or by investing directly in shares yourself. If you have little experience of the stock market then you'll need to do a fair bit of homework before taking this route. Look at this section of the site for more information.
Investing For Income
If you want to live off your lump sum then a slightly different approach is required. The income you can expect from an index tracker (i.e. the UK stock market as a whole) has recently been around 3%. However the capital value of your lump sum and hence the dividends you receive from it should grow over time.
If you need more than this then you have to accept that the capital value of your lump sum is unlikely to grow as quickly. You can get a larger income from a portfolio of shares, say 4% to 5%. In fact we have an illustrative portfolio about this which you can find here. With such a strategy you can still expect the capital value of your lump sum to grow over time, and hence the value of your 4% to 5% should do as well.
If you want more than 4% to 5% then your options are basically confined to a high interest savings account or a high yield fund. With the former your capital is secure but it will not grow over time and it will fall in terms of spending power. In addition, you have to keep an eye on what rate your account is paying and check that it is still competitive.
High yield funds can be very risky. As a general rule of thumb the higher the yield plastered in large letters across the flashy advertisement the higher risk the fund is. Therefore you need to ask yourself how important getting a little bit of extra income is. Is it worth risking your capital for it? Here at the Motley Fool we're not particular fans of this form of investment.
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