Portfolio Management II
Reading 54. Basics of Portfolio Planning and Construction
Learning Outcome Statements
e. describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances and their implications for the choice of portfolio assets;
CFA Curriculum, 2020, Volume 4
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Subject 3. Investment Constraints
- Liquidity needs. Liquidity in the investment sense is the ability to quickly convert investments into cash at a price close to their market value. Investors may need some cash to meet unexpected needs (e.g., emergencies, good investment opportunities) but don't want to sell assets at unfavorable terms. The investment plan must take this need into consideration.
- Time horizon. This is the time between making an investment and needing the funds. There is a relationship between an investor's time horizon, liquidity needs and the ability to handle risk. Investors with long investment horizons generally require less liquidity and can tolerate greater portfolio risk; losses are harder to overcome during a short time frame for investors with short investment horizons.
- Tax concerns. Investment planning is complicated by the tax code. For example, income from dividends, interests, and rents is taxable at the investor's marginal tax rate. Capital gains are only taxable after the asset has been sold for a price higher than its cost or basis, but unrealized capital gains are not taxable at all (the tax liability can deferred indefinitely). Sometimes analysts have to make a trade-off between taxes and diversification needs. Other factors, such as tax-deductible IRA contributions and 401(k) plans (in the U.S.), also complicate this issue.
- Legal and regulatory factors. Individual investors are generally not affected by regulations, but professional and institutional investors need to be aware of regulations.
- Unique needs and preferences. There may be a number of unusual considerations that affects the investor's risk-return profile. For example, investment requirements may depend on goal spending. Thus, individuals will require adequate funds set aside to meet known spending demands. Moreover, many investors may want to exclude certain investments from the portfolio based on personal preferences. For example, investors may specify that no investments in their portfolio be affiliated with the manufacture or distribution of alcohol, pornography, tobacco, or environmentally harmful products.