Chapter 3: Types of Investment Constraints

If you have more than one investment objective, your success may come at the expense of another. Investment constraints limit the various investment options available to you as an investor.

Investment Constraints

The constraints can be broadly classified into:

  1. Internal Constraints- Internal constraints are generated by your own self.
  2. External Constraints- External constraints are generated by an outside entity like a government agency.

The following are the types of investment constraints:

1. Liquidity

Liquidity is the ease of converting assets to cash. Such constraints are associated with expected expenses which are required at a specific time in future and are generally in excess of income available. Moreover, you might also want to keep aside some money for emergencies. Stocks and bonds are more liquid assets than private equity or real estate investments.

2. Time Horizon

These constraints are related to the time periods over which returns are expected from the portfolio to meet specific needs in future. You may have to pay for college education for your children or need the money after your retirement. Such constraints are important to determine the proportion of investments in long term and short term asset classes. Generally, if you have a longer time horizon have the ability to take more risk in their portfolios and require less liquidity.

3. Tax

These constraints depend on when, how and if returns of different types are taxed. If you are an individual investor, income generated from your investments is taxable. The tax environment needs to be kept in mind while drafting the policy statement.

Such constraints are mostly externally generated and may affect only institutional investors. For eg: There may be limits for company directors on trading securities in their firms. These constraints usually specify which asset classes are not permitted for investments or dictate any limitations on asset allocations to certain investment classes.

5. Unique Circumstances

Such constraints are mostly internally generated and signify one’s special concerns like ethical values, religious preferences, etc. Some individuals and philanthropic organisations may not invest in companies selling alcohol, tobacco or even defence products.

Investment Capacity and Suitability

1. Personal and Financial Situation

Does the amount of money you save, spend and invest depend on how much money you are currently making? Obviously it is somewhat dependent on the money you are making. You can invest according to your income and your liabilities. For eg: Someone who has a high paying job, but also has a lot of debt or liabilities, will not have the capacity to invest a lot of money in other assets. Small investments in low risk assets will be suitable for the person.

2. Age

A person’s age largely determines a person’s investment capacity and suitability. For eg: A person aged 25 years will have lesser financial responsibilities and can thus invest more in high risk high reward financial instruments like stock markets. Whereas, a person aged 50 years, will have higher financial responsibilities and will prefer safer and traditional investments which can give him a guaranteed interest post retirement.

3. Investment Goals and Time Horizon

You can have numerous investment goals like buying a house, saving for your child’s education, a vacation, etc. Depending on the goals, the investment time period is determined. For eg: If a person wants to go a vacation with his family within six months, he/she will invest in short term assets which have low risk like government securities. Whereas, if a person wants to save for his/her child’s education for 10 years, then he/she is more likely to invest in long term assets with high risk and high returns like equity mutual funds.

One must plan their investments keeping in mind their investment objectives, constraints, capacity and suitability. Adopting a holistic approach for investment, helps one in making sound financial decisions.

Ekta Vikram

Ekta Vikram