Individuals don’t need to worry about collateralising derivates or the pros and cons of holding very illiquid assets like infrastructure. However, they may still need to think about liquidity.
If their income falls or their outgoings increase, they may need to spend some of their savings to make up the difference. If this is the case, it will be helpful to have some money in liquid and stable assets like cash that can be accessed quickly.
They may also have some illiquid assets. Their home, if they own it, is an obvious example. Personal possessions are also a form of illiquid asset, although this will usually only matter if they need to be sold unexpectedly.
Time horizon-based investing is a close relative of liquidity waterfalls (discussed in the last post) and can be applied to individuals’ financial circumstances.
What is time horizon-based investing?
With time horizon-based investing we first establish our financial obligations over the short, medium and long-term, and then align our investment strategy with each of these.
Cash is held for near term commitments; moderately volatile assets are held for medium-term commitments and more volatile assets are matched to longer-term commitments.
Here is a hypothetical example:
Case study
Sue and Phil are both in their early forties and have built up some savings outside of their company pensions. At present, their income is about equal to their outgoings.
They have an 11-year-old daughter who they’d like to help out financially, should she choose to go to university. Sue and Phil also moved into a new house a couple of years ago and would like to install a new kitchen and bathroom. They took out a large 5-year mortgage to buy the house and would like to reduce this when they next re-mortgage, to get a better mortgage rate.
Sue’s mum is in her late 80’s and not in great health. Sue is conscious that at some point she may need to switch to part-time work from full-time, to spend more time caring for her mum.
What might a time horizon-based investment strategy look like for Sue and Phil?
First, they need to establish the broad timing and size of their various financial commitments. This could be as below. (Note: figures are illustrative only and are in today’s money terms.)
Near-term (1 year or less): New kitchen and bathroom: estimated cost = £20,000.
Medium term (1 year to 5 years): Paying down mortgage on house when mortgage deal expires: estimated cost = £50,000.
Medium to long-term (5-10 years): Helping daughter out financially if she goes to university: estimated cost = £25,000.
Long-term (10 years+): Sue and Phil’s retirement: partly covered by company pensions but would like to put more aside if they can.
Unknown time horizon: Reduction in Sue’s income while she cares for her mum: estimated cost = half of Sue’s salary a year.
Assigning investments
The next step is to assign appropriate investments to each of these buckets. This could look as below. (Note: I’ve assumed that these assets are suitable for Sue and Phil’s risk appetite. You should consider your own circumstance and risk appetite, and take advice, if necessary, before deciding your own strategy.)
Near term (£20,000): Cash in their bank account, instant access savings account or other cash-like investments that can be accessed immediately.
Medium term (£50,000): Fixed term savings accounts.
Medium to long-term (£25,000): Government bonds or highly rated corporate bonds. Lower risk multi-asset funds1.
Long-term (£anything left over): Equities, higher risk multi-asset funds.
Unknown time horizon (£?): Cash in bank account, instant access savings account etc. Here, Sue and Phil will need to make a rough estimate of how much they feel would be appropriate to set aside. They may also wish to set aside a rainy-day fund, in case something else unexpected should happen.
As time passes, time-horizons will shorten. Therefore, Sue and Phil will need to keep their investment strategy under review and re-allocate assets if necessary.
Conclusions
Over the last three points we have explored various topics associated with liquidity:
- What causes assets to be illiquid.
- How institutions manage illiquidity using liquidity waterfalls.
- How individuals can use time horizon-based investing to match their investments to their own liquidity needs.
In the next post we will begin to look at the topic of leverage which, as was seen during the 2022 UK gilt crisis, also has an important relationship with liquidity.
- E.g. funds holding mainly bonds, but possibly with a modest allocation to equities and other assets for diversification. ↩︎
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