Investment Masterclass: Don’t Underestimate The Need For Liquidity

Ian King, Tuesday April 15, 2014

A common trap that many investors fall into is being unable to gain access to your funds at a time of real need, for example, perhaps during a period of falling asset prices or a personal need for cash.

Investment by its very nature should be a medium to longer-term venture. It is not therefore inherently a problem when an investment has, or potentially has, some sort of tie-in or other restriction which may mean that you could not liquidate your investment immediately.

Restrictions

Some common examples of when an investor may be locked into an investment include:

  • Product specific tie-ins: A clause to an investment which means that funds cannot be withdrawn for a set period of time.  The nature of the clause is dictated by the provider of the fund.  Fortunately, such clauses are much less common than they used to be.
  • Tax or wrapper specific restrictions: Given the particular type of investment a general restriction may apply during which exiting the investment is either impossible or very costly.  For example, investments made into pensions cannot be accessed in most cases until the age of fifty-five.  Enterprise Investment Scheme (EIS) will also claw-back the income tax rebate provided on investment if a redemption is made during the first three years of investment. Being tied in to an investment for tax reasons as a result of previous gains would also be an example here.
  • Asset specific issues: It is a fact of investing that certain assets take longer to sell.  Whilst for instance shares in a FTSE 100 listed company can be sold almost instantaneously, shares in private companies can take months to be sold, given the absence of a ready market for the shares.  Anyone who has either bought or sold a house knows how long it can take from identifying a property and agreeing a price to actually moving in.
  • Indivisibility: One common attraction of stock market investing is that the investor has the ability to liquidate a small part of the portfolio usually relatively easily.  Other more illiquid investments, particularly property, need to be sold in their entirety. Without resorting to costly financing it is very difficult to sell a few bricks or a room of the property whilst retaining ownership of the balance!

Liquidity to Risk

Investors in assets which have one or more of the above features should therefore acknowledge the liquidity risk to which they are potential subject. This is especially the case when a degree of borrowing, or other leverage is linked to the investment (e.g. a buy-to-let mortgage on a residential property).

Once the investor has acknowledged the potential liquidity issues of their chosen approach they must “stress test” against various scenarios during which they may require access.  Do they have sufficient other sources of funds to meet those requirements without needing to access the potentially restricted investment?

Implications

It is frequently the case that investments, which are at least inclined to be illiquid, form a large part of an investors’ portfolio; and there is no inherent problem with this approach.

The investor just needs to be aware of the implications of their actions, the likely impact that this may have in a worst case scenario on their financial stability and finally the need to make sure they are compensated for this extra risk by the potential for extra return.

So, the question is how are your investments positioned in the event of an emergency? Could access to your investments be restricted and if so, what would this mean to you?

As always we welcome your feedback.

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