THE BEECHMONT CREST ONLINE GUIDE TO STOCKS AND INVESTING
Investment constraints
For every investor, limits on risk and return are imposed by three investment constraints: liquidity needs, time horizon, and tax considerations. These must be taken into consideration when planning the investor’s portfolio.
Liquidity needs
Which investors have high liquidity needs?
Retirees and older investors
Wealthy individuals with high tax burdens
Younger investors who are anticipating significant expenses in the short-term (such as educational costs)
Which investors have lower liquidity needs?
Younger investors who are primarily investing for retirement, or expenses in the longer term.
But…..
Older investors still have to take inflation into consideration. The value of highly liquid investments (such as CDs and savings accounts) are eroded by inflation.
Likewise, younger investors may experience a sudden need for greater liquidity: in the event of a layoff, or any other unexpected expense
Which assets are most liquid?
Other than simple savings accounts, the most liquid assets are those for which there is an established market with many buyers, such as treasury bills.
Assets like real estate, which may require a lengthy search for a buyer, are less liquid.
Time horizon
There is a close relationship between an investor’s time horizon, liquidity needs, and tolerance of risk.
Investors with long time horizons (generally, younger investors) have less need for liquidity. They can tolerate more risks. Investors with short horizons face the opposite scenario: They require higher portfolio liquidity, and cannot tolerate as much risk.
Tax considerations
Taxes complicate all investment decisions. Portfolio-based income often includes interest and dividends, both of which are taxable at the investor’s marginal tax rate.
Capital gains
Capital gains arise from a change in the prices of assets. Capital gains are taxed differently than income. Tax is paid on income when it is received. An investor is only liable for taxes on capital gains when an asset is sold.
Unrealized capital gains are price increases on assets that have not been sold.
Realized capital gains are profits on an asset that has been sold at a higher price.
The basis of an asset is its cost to the investor. When an asset is inherited, the value of the asset at the time of the original investor’s death becomes the new basis.
Consider this concept in terms of your Aunt Millie’s portfolio. Perhaps Aunt Millie has been holding some assets for a number of years, and they have significantly increased in value.
If Aunt Millie were to sell the assets herself, she would have to pay capital gains taxes on the profits.
If, however, Aunt Millie wills these assets to you, the value of the assets at the time of Aunt Millie’s death becomes the new basis. This means that you can sell the same assets without paying capital gains taxes.
