A portfolio manager is reviewing the liquidity constraint for a 70-year-old retired client. The client relies on portfolio withdrawals for a significant portion of their living expenses and anticipates a large, one-time expenditure for medical care within the next year. Which of the following adjustments to the portfolio's asset allocation would be most appropriate given this information?
- AIncrease allocation to cash and short-term fixed income.
- BIncrease allocation to high-dividend growth stocks.
- CIncrease allocation to long-term government bonds.
- DIncrease allocation to private equity funds.
Show answer & explanationAnswer & explanation
Correct answer: A. Increase allocation to cash and short-term fixed income.
The client has high liquidity needs due to reliance on withdrawals for living expenses and an anticipated large, one-time medical expenditure within the next year. Increasing the allocation to cash and short-term fixed income provides the necessary liquidity to meet these known and anticipated short-term cash flows without needing to sell longer-term, potentially volatile assets at an inopportune time.
Why the other options are wrong
- B. High-dividend growth stocks still carry equity market risk and their value can fluctuate, making them unsuitable for specific, near-term liquidity needs.
- C. Long-term government bonds are subject to interest rate risk and may not provide immediate liquidity without potential capital losses, making them less suitable for short-term needs.
- D. Private equity funds are highly illiquid, making them completely inappropriate for a client with significant near-term liquidity needs.
Liquidity Constraint & Asset Allocation
The liquidity constraint in an IPS dictates the need to hold sufficient liquid assets to meet anticipated and unanticipated cash outflows without disrupting the long-term investment strategy.
- High liquidity needs require a larger allocation to cash and short-term instruments.
- Low liquidity needs allow for greater allocation to illiquid, higher-return assets.
- Influenced by income stability, spending habits, and anticipated large expenses.
- Must be balanced with return objectives.
Memory trick: When cash is tight, and needs are near, short-term assets quell all fear.