What to do with a $20,000 inheritance

A reader knows there must be a better option that using a plain-vanilla savings account.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: I've just received a small inheritance of about $20,000. Is there something I can do with it that's smarter than just sticking it in a savings account? - Liz, Fairbanks, Alaska

Answer: Sure, there are plenty of smarter things you can do than just throwing it into a savings account where it will languish paying just a few percent a year. But before you do anything, you first need to think about what your plans are for that money.

The two most important questions: what do you need it for and when will you need it?

Say you'll have to tap into your inheritance within the next few years - for a down payment for a car or house, for example. Then the needed money should go into an investment where the principal will be secure and you can access it quickly without penalty.

That means you want an investment that isn't vulnerable to wide swings in returns and that isn't going to experience any sizeable setbacks.

A savings account would qualify, but you may be able to earn a higher rate of interest by putting this money into a money-market fund. It will be safe there and it will earn a decent, although hardly earth-shattering, rate of interest, lately around 4 percent to 5 percent. Keep in mind, that rate will change on a daily basis, depending on the level of short-term interest rates.

Virtually all money-market funds also allow you to write checks on your account. To see what the highest-yielding money-market funds are paying, click here.

If you're willing to take a bit more risk, you can usually get a slightly higher return by going to an ultra-short bond fund, which typically invests in debt instruments with maturities of six months to a year, or a short-term bond fund, which invests in bonds with a maturity of no more than a few years. You can find such funds by revving up Morningstar's Fund Screener.

Beware, though, that the share price of ultrashort and short-term bond funds can drop when interest rates rise, although typically they don't get hit very hard. That said, you still wouldn't want to put your entire ready-money stash in one of these funds. In fact, I'd say you'd probably want well less than half of this portion of your savings in these alternatives, making the money-market fund your main ready-money stash.

Once you've set aside this portion of your inheritance, you can begin thinking longer-term with the rest. That means investing in a blend of stocks and bonds or, in your case, since I sense you're a beginner in all of this, stock and bond mutual funds.

Coming up with a mix of stock and bond funds that makes sense for you is something you'll also have to give a bit of thought to. One thing to think about is how long you plan to have this money invested. The longer you can leave it untouched, the more you can devote to stock funds in the hope of earning a higher long-term return.

The other thing you ought to consider is your appetite for risk. If it would make you really anxious to see the value of this portion of your holdings decline, then dial back your exposure to stock funds and devote more to bond funds, since their value doesn't jump around as much.

On the other hand, you don't want to totally wimp out. If you hunker down almost completely in bonds, your money won't grow as much over the long-term. So what you're really trying to achieve is a blend of stocks and bonds that gives you a decent shot at superior long-term gains, but doesn't make you so nervous that you can't sleep at night.

To arrive at a stock-bonds blend that makes sense for you, I suggest you check out the Asset Allocation Wizard on our site. You just answer a few simple questions and voila! You get a suggested mix of stock and bond funds that should be about right for you.

If you want to go a step farther, check out the Asset Allocator tool in the Investment Tools section of T. Rowe Price's site.

By moving a couple of sliders to duplicate the mix you got from our tool, you can get a quick estimate of how that mix might actually perform. And you'll see how that mix fared in its worst three-month period, which can give you a sense of whether that blend is too racy for you.

As for putting that mix into action with specific stock and bond funds, you're in luck. Money Magazine just published the MONEY 70, which is its roster of recommended funds.

Yes, faithful readers will recall that this list used to be called the Money 65. We've added a new category as well as a few more funds to provide wider diversification, bumping up the number of finds in our lineup, hence the new moniker.

In any case, by perusing this list, you can easily create a nice little fund portfolio for yourself. Or, if you prefer an even easier way to create an portfolio, you can buy one of the target-retirement funds on the list. For more on how these "no brainer" funds work and why they're a good solution for people who want diversification but don't want to work hard to get it, click here.

I'm going to leave you with one final smart thing you can do. Once you've settled on a stock-bonds mix and arrived at a portfolio of funds, don't start fiddling with your holdings. Monitor them every quarter or so. And if a fund has really been stinking up the joint for a year, keep an eye on it, and maybe dump it if it performs terribly for two years.

But otherwise, all you want to do is rebalance your portfolio every year or so, selling some shares of winners and plowing the proceeds (or new money you may be investing) into the laggards, to bring your portfolio back to its original proportions. (If you buy a target-retirement fund, you don't even have to do that. The fund does it for you.)

If you follow this approach and add some of your own savings to what you've inherited, who knows. Maybe your money will grow enough so that you'll be able to leave an inheritance to some lucky heir of yours one day.

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.