Chapter 5

Investment Constraints

What else to consider beyond return and risk objectives?

‘Nothing is more difficult, and therefore more precious, than to be able to decide.’

Napoleon Bonaparte

The two investment objectives are return and risk. Return objective defines what you want your investments to achieve – the outcome. Risk objective defines what risk level you should and can bear – the journey’s volatility.

However, you may have other considerations and constraints influencing your portfolio. Beyond the two investment objectives, consider five groups of investment constraints:

1. Time horizon.
2. Liquidity.
3. Taxes.
4. Legal and regulatory.
5. Special circumstances.

Time horizon

Time horizon is the period over which you invest. It outlines when you will need the money.

For example, if you are 25 and save for expected retirement at 65, your time horizon is 40 years. If you are retired at 65 and your life expectancy is 90 years, the expected time horizon is 25 years. If you live longer, to the age of 100, your time horizon unexpectedly increases to 35 years. Hopefully, your portfolio was designed to survive 35 years, not only 25.

When planning and investing, expect the unexpected. Hope for the best but plan for the worst. Always have a margin of safety.

Your overall time horizon can be divided into separate phases. For example, 40 years until retirement, 40 years post retirement and perhaps perpetual after death, leaving an inheritance. The return and risk objectives for each phase are probably different.

Generally, the longer your time horizon, the higher the risk level you can assume. A rule of thumb says the proportion to invest in equities is 100% minus your age. When you are 20 invest 80% of your portfolio in equities. When you are 70 invest only 30% in equities. This is not accurate – do not follow this rule to its letter. But it does demonstrate the relationship between time and risk.

More time allows taking more risk. You have time to recoup losses so your ability to take risk is higher. You should have more appetite for volatility.

Markets tend to crash every number of years. If you panic and sell after the crash at the market’s bottom or cannot stay invested, you crystallise the losses. But, if you wait patiently, markets rebound. It can take a long time, but they have always recovered eventually.

The markets have done so following the crashes of 1987 (Black Monday), 1998 (Russian default crisis), 2000 (high-tech bubble burst), 2008 (global financial crisis) and 2011 (European sovereign debt crisis). However, if you have no time and are forced to sell, then you cannot wait for a recovery. Had you retired in 2011, for instance, you would not have had time to recover from the 2008 and 2011 crises.

Lengthy time can justify investing in expensive investments. It allows generating returns to rationalise costs. For example, buying and selling a property could cost over 7%.¹ With a time horizon of only one or two years, stay away. The return might be insufficient to cover the expenses. However, with 10 years, investing may justify the costs since total return can comfortably surpass 7%.

Time justifies holding illiquid investments. Since you do not need to sell them any time soon, you can tolerate liquidity risk, which brings liquidity premium.

Back to the property example, if you must sell it after two years, you might lack enough time to wait for the right buyer or for supportive market conditions. With more time, you can be patient, selling when you want, not when you must.

A longer time horizon permits a higher risk appetite, flexibility and additional options. Critically, it enables accumulating money and returns, benefiting from compounding. That is why the sooner you start saving and investing the better.

If your time horizon is short, invest only in safe, conservative investments. For example, if you need your money next year, avoid equities. Their price can fall within a year and you cannot remain invested to make back losses. Instead, invest in cash deposits and short-term bonds without risking capital.

A long investment horizon is also emotionally reassuring. Checking your portfolio’s performance every day, you will experience good days, when making money, as well as bad days, when losing money. This could be frustrating and psychologically draining. Do not do this to yourself. Anyway, unless you are a day trader, do not change your portfolio based on one-day movements.

With a really long time horizon, try refraining from high-frequency performance monitoring. Focus on the big picture over the long term. This can help to avoid making irrational, emotional investment decisions based on fear or greed.

Pension freedom means that no longer are you forced to sell your investments when retiring to buy an annuity. You can keep investing, extending your time horizon, at least with part of your portfolio.

Time is an invaluable luxury. The amount of time at your disposal shapes your portfolio – influencing its risk level, the types of investment it includes and how often you should review its performance.

Liquidity

Liquidity measures the marketability of investments – the cost and time to turn them into cash. Liquidity constraint determines the fraction of your portfolio holding liquid investments.

Some assets are liquid whilst others are illiquid. When selling a UK equity fund, for example, you can usually do so within two days, depending on its settlement period and dealing frequency – it does not take too much time.²

It involves some transaction costs. You will be charged for them, as they are reflected in the price you receive when selling your shares in the fund. However, UK equities are normally liquid so trading them does not involve high costs.

Selling property is a different story. It may take several months to hire an estate agent, publish your property, find a buyer, and go through the legal process of exchanging contracts. Transaction costs involve payments to estate agents, solicitors and perhaps CGT. Luckily for sellers, stamp duty (Stamp Duty Land Tax – SDLT) is levied on buyers. Selling property takes time and money. It is illiquid.

Cash is the most liquid asset. You can use it to buy and pay for whatever you require (as long as money can buy it). Liquidity constraints reflect your need for cash or assets that can be turned quickly and inexpensively into cash.

Liquidity needs are divided into expected and unexpected.

If you know when and how much cash you will need, plan to have it at hand. For example, your child’s £10,000 university tuition fee is due in one year. The annual interest on 12-month term deposit is 2%. You put aside £9,804 in the deposit, letting it grow to £10,000 in one year. It is relatively easy to plan for expected liquidity needs.³

Unexpected liquidity needs include a cash reserve to cover unexpected payments. For example, your car might break down, requiring an urgent replacement. Keep some cash in your bank account to quickly pay for contingencies.

Some cash should be available to exploit emerging investment opportunities. For example, if you are looking to buy a property, having sufficient cash for a deposit or, better yet, to be a cash buyer, can give you an advantage. The trade-off is opportunity cost – the return the cash could have made had it been invested.

By blending different investments with different liquidity characteristics, design a portfolio meeting your liquidity needs. One challenge is that liquidity of some investments changes. Liquidity is ample when you do not need it, but it can dry up when you need it the most. It is also seasonal. During December, for instance, liquidity is low, due to the holiday season.

For example, you hold corporate bonds. In normal times you can readily find willing buyers. However, when financial conditions are stressed (like they were in 2008) and everyone looks to sell corporate bonds, it might be impossible to find buyers. Liquidity is gone. You can either wait until it is back or drop the price of your bonds until someone is willing to buy them at a bargain price. You can sell almost everything; it is a question of price.

Illiquidity can come with a cost. If you need cash quickly, you might incur losses on assets you are forced to sell at fire-sale prices. This is liquidity risk.

Your DC pension before you are 55 and annuities are illiquid. ISAa can be liquid. Pension freedom means your pension can be liquid after retirement.

Liquidity constraint means keeping some assets in cash or close to cash (such as liquid gilts). Since you cannot access your pension before retirement and you should not raid your ISAs unless you must, keep some cash in a bank account.

Taxes

‘In this world nothing can be said to be certain, except death and taxes.’

Benjamin Franklin

We have discussed taxes at length already; we will not do it again.

You pay income tax on your salary, interest and rental income. You pay tax on dividends. You pay CGT on capital gains. You pay stamp duty when buying UK equities or properties. You pay Value Added Tax (VAT) when buying some goods and services. And you pay IHT when you leave this world. Taxes are everywhere.

Taxes eat into returns. A basic investing principle is to minimise costs and taxes – this is one of the only ways to enhance returns without taking investment risks.

One of the major incentives to save within pensions and ISAs is favourable tax treatment. When hopefully earning interest and capital gains, they are sheltered from tax as long as you keep the investments in a pension or ISAs.

When withdrawing pension benefits after retirement, you have deferred income tax payments by many years. Time value of money plays in your favour. Instead of paying taxes today, paying them in the future is valuable.

This is an advantage of pensions over ISAs. You save money in ISAs after paying income tax, but you do not pay tax when taking money out (taxed, exempt, exempt – TEE). You put money in a pension without paying income tax, but you pay it later when drawing money (exempt, exempt, taxed – EET). The British Government is contemplating whether to switch pensions from an EET to a TEE regime.

Maximise contributions into your pension to the maximum permitted by law. Maximise yearly savings in ISAs. Tax savings can make a massive difference. Mitigate your tax bill as much as legally possible.

Tax constraint means you should invest in pensions and ISAs as much as possible rather than elsewhere. It limits your accessibility to your investments, encouraging long-term investing.

Legal and regulatory

Pensions and ISAs are heavily regulated. Regulations dictate the types of pensions and ISAs you can have, how much you can save, at what age you can retire and what you can and cannot do with your money when retired.

Regulations continuously change. Keep yourself informed and updated. The regulations seem complex and intimidating. However, they are meant to be understood by unprofessional savers outside of the pension or investment community.

Visit www.gov.uk often, familiarising yourself with your rights and obligations, as well as those of your employer, if relevant. Consider taking professional advice.

When the chancellor announces the budget, it includes key changes to regulations about savings and pensions. It would be all over the news.

Just as the rules governing pensions and ISAs have been changing during recent years, they might change again in the future. Build some flexibility into your planning to allow for this. While the main objective of pensions was income before pension freedom, now it is also the flexibility to access capital.

Legal and regulatory constraints shape the way you save and invest for retirement.

Special circumstances

Special circumstances are a residual category of constraints that are not covered by the other four groups. Unique to you, they cover any constraint you wish to impose.

For example, responsible investing (so-called Socially Responsible Investing – SRI, or Environment, Social and Governance – ESG) can include avoiding investing in companies in vice sectors, such as tobacco, alcohol, gambling, defence and porn (exclusions) or investing in companies with sustainable businesses (inclusions). You may buy such investments because of ethical reasons or since you believe they will generate superior returns.

Impact investing is investing in companies, organisations and projects with a positive impact on the environment or society, such as microfinance, green energy, clean drinking water and low-income housing.

Sharia law is a set of Islamic rules. It has restrictions on payment and collection of interest, investing in companies involved in prohibited businesses, using derivatives, since they might involve gambling, and day trading.

You are managing your portfolio for your future. You are the boss. Decide how to manage your assets. You are free to put whatever constraints you desire.

The caution is that you are limited by the available funds and investments in your pension and ISAs. For example, not all platforms offer choices of responsible investing. Your constraints are constrained by the available choices.

Free your manager

The more constraints you enforce on your portfolio or fund managers, the more difficult it is to generate returns. This stems from the philosophy of aspiring to have the widest investment opportunity set, which is the universe of investment choices. More choice means more freedom and flexibility.

Free your manager. A skilled manager can potentially turn choice into better results. If managers are unskilful constrain them. Better yet, if they are unskilful do not use them in the first place.

Constraints go against choice and freedom. Minimise investment constraints.

Establishing objectives

The return and risk objectives, complemented by investment constraints, form your investment objectives. We have completed the first step of the investment management process.

When planning for retirement, first form a realistic vision. How do you imagine your retirement? What kind of lifestyle do you wish to live? Where do you want to live? What financial resources do you need to make your vision a reality? This is the ultimate reason for saving and investing for retirement – your investment objectives.

Next, plan how you are going to achieve your vision. What actions will you take from now on for the rest of your life to progress you towards your vision? This plan is the investment strategy.

Summary

• Investment constraints complement the return and risk objectives to define how to design and manage your portfolio.
• Time horizon is critical to the ability to take risk and returns you should expect. Longer time means higher risk tolerance, higher potential returns, more time to accumulate money and letting compound return work.
• Liquidity constraint is the proportion of assets you keep in cash or to be able to quickly and inexpensively turn into cash to meet expected and unexpected liquidity needs. You cannot access your pension before retirement and you should not access your ISAs unless you must. Keep a cash reserve in your bank account, considering the opportunity cost.
• One advantage of pensions and ISAs is favourable tax treatment. Do everything that is legally permitted to minimise your taxes.
• Pensions and ISAs are heavily regulated. Keep yourself updated.
• Special circumstances include any other constraint you wish to impose on your investments.
• Avoid constraining yourself and your fund managers since it limits the choices that potentially can be turned into better results.

Notes

¹ The costs of buying and selling property include stamp duty, mortgage fees, legal fees, estate agent fees, renovations and removals.

² Daily dealing and daily pricing mean a fund can be traded every day and its price is published every day. Some funds have less frequent dealing and pricing, such as weekly or monthly.

³ £9,804 = £10,000 ÷ (1 + 2%).