Research on various financial constraints has flourished in the 21st century, but most of the literature is devoted to understanding the constraints on enterprises. Constraints are equally important to the financial situation of an individual or family, and a well-trained financial advisor can play a key role in helping clients understand the constraints of their own goals. This is true whether the client wants to buy a holiday home, start a business, or just plan to retire early.
- Financial constraints are things that restrict the process of economic action and must be adapted.
- For example, your broker may restrict your short selling, options or margin trading, thereby limiting your investment range.
- Financial constraints are the real issue and should not be confused with subjective or emotional excuses for not following a specific course of action.
- For many people, retirement income becomes a constraint on spending and consumption in old age.
Types of financial constraints
Financial constraints are specific and objective obstacles, not general or subjective. This distinguishes constraints and its research from common excuses such as “I don’t have enough money to invest in this stock” or “I just have a hard time understanding investment”. Think of it as the difference between telling someone which highway to take between Kansas City and Denver and drawing them a route map with specific information about speed traps, bad weather conditions, or long sections of road without gas stations. the difference.
For investors, financial constraints are any factor that limits the quantity or quality of investment options. They can be internal or external (the above examples can all be regarded as an internal constraint, such as lack of knowledge or poor cash flow). Every investor faces internal and external constraints.
Some limitations are common sense. For example, every investor needs to understand their own time frame limits. The same applies to a client with a five-year-old daughter who wants to save enough money for her four-year college education, while a 50-year-old client lags behind in retirement investment and wants to stop working before the age of 70.
All customer investments face tax restrictions. When discussing the client’s retirement goals, specify the negative impact of taxes on all realized gains and income generated (including post-retirement). If a client wants to start a business or invest in alternatives, such as precious metals or artworks, be sure to emphasize all legal and regulatory restrictions. High-net-worth clients may have special interest in charity organizations or travel, but each has limitations and opportunity costs.
Liquidity risk management
Liquidity risk management is a typical example of a field that has been thoroughly studied in the business field but is rarely applied to personal investment in a systematic manner. In short, liquidity risk is the risk that a given economic entity (for example, an individual, a company, or a country) may temporarily run out of cash. Almost every investment involves assets that are less liquid than cash, so investors and their advisors must consider how the investment limits future cash flow.
Retirement plans combine four types of financial constraints: liquidity risk, time frame, taxation, and legal/regulatory constraints. If you recommend that a 35-year-old customer deposit $5,000 into an individual retirement account (IRA) each year, please understand that this person will actually spend $122,500 in an illiquid account for the next 24.5 years. With a few exceptions, your customers will not be able to retrieve these assets without paying a large fee to the government.
Not spending the additional $122,500 is a limitation and needs to be clearly stated. Your clients should understand the trade-offs between not spending $122,500 before retirement to get more than $122,500 in post-retirement income.
Avoid overspending when you retire
When Social Security was first created, the average life expectancy of Americans was less than 65 years. It is expected that less than half of the contributors will benefit from the system. Unsurprisingly, in the 1940s and 1950s, private companies could provide higher pensions, when the average life expectancy was much lower.
The average life expectancy of Americans born in 2018 is about 78.7 years.Longevity is a blessing and a constraint. If your client plans to live to 85, he will not be able to spend 10% of his retirement savings every year after 65. Financial advisers have a responsibility to help their old clients avoid excessive retirement spending.