Personal Finance Basics: Portfolio Constraints (Video)

Apologies for the delay!!!

Script:

Hi all,

I’m Ramon Cuenca, founder and director of Art and Finance, the website that makes learning Finance fun and accessible

Now that we’ve gone over the return and risk objectives, let’s talk more about real-world issues that  you would have to face when organising your finances. These considerations may influence your return and risk objectives. We will formally refer to them as the constraints to your portfolio.

There are five categories of constraints to your portfolio:

Liquidity

Time Horizon

Taxes

Legal and Regulatory Environment

Unique Circumstances

Let’s start with the first on the list, liquidity.

Liquidity is a measure of your portfolio’s ability to fund anticipated and unanticipated needs for cash. The key word here is cash. You can’t always put all of your money in volatile stocks, for example, when you need cash. One example of how liquidity may constrain your portfolio is using cash to pay off loans instead of investing the cash in stocks.

More formally, liquidity requirements for cash from your portfolio include:

Ongoing expenses – As we highlighted in our video on the return objective, you can start with an after-tax cashflow analysis of whether your income meets your expenses and how much of the shortfall you may have to make up with your portfolio. For further information, I’ve also included links to several Business Insider articles on how real people have gone about their budgeting.

Emergency reserves (self-explanatory)

Negative liquidity events (for example, a major expense or donation)

Positive liquidity events (an inheritance, for example)

External support (an example is someone else giving you money)

Next, let’s look at time horizon. For many people, different stages of life require different asset allocation strategies. The classic example is someone in her 20’s with a stable job and plenty of time to benefit from the long-term price appreciation of stocks, versus someone in her 80’s, retired and living off income from her bond portfolio.

One simple way to understand why your asset allocation may change over your time horizon is because your human capital changes as well. Human capital is the present value of your labor income. If you don’t understand present value, you can take a look at our blog post on it, which is in the description. Anyway, human capital forms one half of your total wealth, with the other half being financial assets. Human capital is therefore also an asset, and you should treat is as such.

Now, the idea is that, assuming you work, earn money, and save, your human capital decreases as your financial assets increase as time goes on. At a younger age, you generally have high human capital, but few financial assets.This allows you to invest a larger amount of your savings in riskier assets, such as stocks. This is because your high human capital serves as a hedge in case you lose money in stocks; for example, if you lose money, you can make it back because you have time to earn more money from your job. The older you get, the case becomes more of the opposite: you have less time to earn money, so all in all your financial assets should be more conservative in nature. I should highlight now that this isn’t dogma – your own specific situation may compel you invest in conservative assets at a younger age, for example.

Financial loss is not the only risk to your total wealth you face, however. Mortality risk, or the risk of dying early, is another one. Aside from the obvious loss of life, this is also a loss of human capital to your family. Therefore, the hedge against loss of human capital is life insurance.

A third risk is the opposite of mortality risk, longevity risk. As you may have guessed, this is the risk of outliving your assets, meaning you’ve spent it all but you’re still alive! Longevity risk is hedged with social security and defined benefit pension plans, since these two sources provide income that can’t be outlived. You can also hedge longevity risk with lifetime annuities – an insurance product where you give a company money and they pay it back to you over the course of your life. Annuities also help hedge against spending risk, where you spend too much of your savings too quickly.

Moving on, let’s talk about taxes. While taxes vary from country to country, they can be categorized as follows. Taxes on:

Income – such as wages, rent, dividends, interest.

Gains – think of buying a stock, holding it for a couple of years, then selling it. You could be taxed upon selling the stock. Gains taxes are a special consideration for the entrepreneur if he sells stock of his company.

Wealth Transfer – this refers to transfers of wealth, not outright sales

Property – this generally applies to real estate, which is often assessed annually

Taxes have considerable implications on your portfolio. If your investments are taxed at the end of a holding period, you pay a cumulative tax. If your investments are taxed periodically throughout a holding period, you pay a periodic tax. The cost of a periodic tax is higher than that of a cumulative tax.

Given such considerations, savvy investors opt for strategies to reduce the amount of tax paid:

The first strategy is tax deferral – for example, a low turnover rate in your portfolio means fewer taxes to pay.

Next, we have tax avoidance, and when I say avoidance, I mean legal avoidance, such as placing your assets into a special tax-exempt account.

Tax reduction strategies also exist, such as tax-loss harvesting, where you sell some assets at a loss to offset any capital gains tax you may have to pay.

Let’s move on to Legal and Regulatory Environment and Unique Circumstances. I won’t spend too much time with these two constraints given that they vary among individuals.

Legal and Regulatory Environment – just be aware that legal structures, such as a personal trust, for executing your portfolio strategies vary from country to country.

Unique circumstances, such as if you want to do socially responsible investing, must also be considered.

And that wraps up our video on portfolio constraints. Be sure to tune in on 24 April, where we conclude our mini-series on Personal Finance with a “How-To” video on investing. See you then.

Ramon Cuenca, CFA
Equities Analyst
Art and Finance

Assistant: Mack Agbayani

Sources/Links:

CFA Curriculum Level III, volume 2, pp. 117-120, 191-192, 204, 320, 331, 342-348

Forbes definition of lifetime annuity

Investopedia definition of lifetime annuity

Business Insider articles on budgeting:

http://www.businessinsider.com/excellent-budget-from-a-25-year-old-2015-1

http://www.businessinsider.com/budget-happiness-2015-4

http://www.businessinsider.com/budget-of-a-retired-couple-2015-3

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