Individuals often consider their goals and objectives when investing, but fail to focus on their personal constraints.
However, investor constraints require equal consideration as they play a substantial role in one’s investment strategy.
Constraints are limitations or restrictions that are specific to each person. Some may be common to many people, others may be unique to that one individual. Today we shall look at a few.
Liquidity Requirements
Liquidity is an investment constraint for most individuals.
The need to always have some cash on hand to deal with daily expenditures or planned purchases necessitates that one avoid certain investment options for a portion of one’s assets.
Three common liquidity needs are emergency funds, planned acquisitions, and investment opportunities.
Emergency Funds
Most investors require a portion of their assets in cash to cover required expenditures, such as mortgage and loan payments, rent, food, transportation and other necessary living costs.
Some experts recommend maintaining 2-3 months spending in emergency funds. In uncertain economic times, when there is a higher risk of employment loss, 3-6 months costs in your emergency fund may be more appropriate.
Another reason for the greater number of months is that many readers are young with relatively low salaries and little in the way of investments or wealth. As you increase your salary levels and begin to build up an investment portfolio, then you may consider reducing your emergency funds to around 3 months of required expenditures.
Short Term Planned Acquisitions
Many individuals plan to make major personal expenditures in the near future. This may be a car, home, travel; anything that requires a large payment at a specific date.
Planned acquisitions require individuals to structure their investments so required amounts are available in cash at the due date. This may result in liquidity constraints as you set aside other funds to make the major expenditure.
For example, investments in venture capital typically have a payback period of between 12 and 14 years. Venture capital is usually an illiquid asset. Therefore, it may be difficult to recover your capital quickly should the need arise.
If you want to maintain $10,000 in liquid assets for emergency funds, you should use it to invest in a venture capital project. In this case, the need for ready cash constrains your investment choices to highly liquid and secure investments.
Investment Opportunities
As you get older and accumulate some wealth, I suggest keeping a small portion of your assets in liquid form at all times. This allows you to take advantage of investment opportunities that may suddenly arise.
If you do not have any liquid assets, then you will have to dispose of another asset in order to purchase the new investment. And when you are forced to sell something at a time other than of your own choosing, often you will not get the best price for it.
But by maintaining about 5% of your wealth in liquid assets, you should always be able to take advantage of interesting opportunities. Obviously, that percentage fluctuates based on your total net worth and desired amounts to hold for unexpected opportunities.
Time Horizon
As we saw in our Life Cycle analysis, investment time horizon can be a plus or a minus to one’s strategy.
As the time horizon until your financial objective decreases, the variety of assets in which to invest also diminishes. Also, the less the time horizon, the less volatility or risk an investor can tolerate in his portfolio.
Tax Issues
After-tax returns are what investors should be most concerned.
You cannot re-invest and earn compound returns on money paid to the government in taxes. Your investment goal should always be to maximize after-tax returns, not gross returns.
Personal Tax Bracket
The tax bracket that the investor is in will impact investment decisions.
If an investor is currently in the highest bracket, she may want to avoid investments that generate taxable income while she is in the top tax bracket. Instead, she may prefer to invest in assets that experience future capital gains. Hopefully, these gains will not crystallize until she has moved into a lower tax bracket.
The same applies to an investor who is in a secondary tax bracket. He may need to be careful about generating too much annual interest or dividend income to avoid being pushed into a higher marginal tax rate.
In both examples, the investors may also be very interested in tax-free investments and/or tax deferred investment accounts. The availability of these investments and accounts varies greatly between tax jurisdictions.
Tax Laws
Tax laws also play a significant role in one’s investment decisions.
In some countries, like Canada, interest income is taxed at a higher rate than certain dividends or capital gains due to tax credits and lower inclusion rates.
If you reside in a country that has different tax rates for different types of investment income, it should affect your investment choices to some extent.
For example, perhaps you live in a jurisdiction where interest income is taxed at a higher rate than dividend income. You have to choose between two investments of equal risk, both offering the same gross return. One pays out interest, the other dividends. You would select the one with the better after-tax return. In this example, the dividend stream.
Many countries offer tax-deferred investment accounts. There are often limitations on annual contributions to the accounts and the possible investments that may be held. Again, this will constrain your investment strategy.
For example, a Canadian Registered Retirement Savings Plan (RRSP) has a 2017 contribution limit of 18% your 2016 earned income, subject to a maximum CAD 26,010. An RRSP will also have restrictions on what investments can be made. A self-directed RRSP provides much more investment latitude than a non-self-directed. But you still cannot hold certain assets such as Bitcoins, uncovered calls, stocks from non-designated exchanges, etc.
Legal and Regulatory
The legal and regulatory environment may also constrain one’s investment decisions.
Typically this is a more important consideration for institutional investors than for individuals. However, there are areas in trusts and foundations where legal issues can be a problem for investment options.
For those of you in public accounting, banking, or law, you may experience issues here.
For example, if you audit a public company, you may be precluded from owning shares in that company. Or if your bank is performing certain work on a company, you may have a blackout period for trading shares in that corporation.
The same may apply in respect of insider trading laws. If you have non-public knowledge, you may run afoul of securities’ laws.
Your sister is president of a publicly traded company and tells you the company is about to be sold for a huge premium. If you go out and buy shares in the company prior to the announcement, you run the risk of being charged with insider trading. You also may run into difficulties if she did not tell you and you coincidentally bought shares a day before the announcement. So whenever there is the potential for issues with an investment, take care.
Unique Circumstances
Finally, many unique circumstances can constrain one’s investment strategy.
Some are self-imposed, others are forced upon the investor.
Certain investors believe in ethical investing. That is, they do not want to invest in companies that they consider unethical. This might include tobacco or alcohol companies.
It may also include companies that operate in certain countries. This was common practice among many investors during Apartheid in South Africa. Today there are countries which by personal choice, or even through laws in some jurisdictions, that prevent individuals from investing in them.
The US currently has legislation that severely restricts trade or investment in Iran. If you try to invest in Iran or Iranian companies, you may be subject to prosecution. Note that this could also be considered a legal constraint.
Other unique circumstances include the ability to purchase certain investments.
For example, a new Initial Public Offering (IPO) may only be available to the best clients of the brokerage house marketing the offering. Or some hedge funds may only be open to investors with extremely high amounts of money. Some mutual funds may no longer accept funds from new investors.
By now you should have some ideas on where you are in life cycle, what some of your investment objectives are, and some of the constraints that you face.
You also may have formed an opinion on your risk tolerance and investor profile.
Next week we will look at asset classes. Probably not too much detail on the actual descriptions, but more how they tie into risk tolerance and one’s investment strategy.
