Conventional wisdom says not to invest cash you will need in the next 12 to 24 months.
The theory goes that over the long term markets rise more than they fall, but rarely when we want them to. Attempting to meet definite financial commitments using investments with uncertain valuations would be tempting fate.
Which is sound reasoning.
Picture how unsympathetic the tax authorities would be if you had bet all the money earmarked to pay your income tax bill on some hot new cryptocurrency pump and dump scam. Try explaining to your loved ones that you lost the kids’ school tuition or your elderly parents’ care home fees in a contrarian Russian Ruble FX play that didn’t pan out.
So far, so sensible.
But what if your funds are already invested?
Where is that house deposit you have been diligently squirrelling away since the day you finished school?
Sat in a savings account, having its purchasing power eroded while earning a below-inflation return?
Maybe quietly compounding away, invested in low-cost passive index tracker funds?
Perhaps it is sunk into speculative crypto and NFT holdings, hoping for a repeat of that get rich quick action, circa late 2020?
How long do you trust your hard-earned savings to the whims of the market gods? At what point do you cash out, the opportunity cost of uncertainty outweighing the benefit of potential future gains?
Consider the journey of a typical first home buyer.
Grinding away at the start of their career. The marketable value of their time a mere fraction of what it may one day become. Working. Renting. Attempting to save. Little flowing in. Lots flowing out.
After a year, or ten, their number reaches critical mass.
Sufficient to secure a home loan, without being stung for lenders’ mortgage insurance. A threshold below which aspirational owners can’t reliably afford the properties they wish to purchase.
After years of watching from the sidelines, the ambitious homebuyer commences their house hunt.
Beginning with dreams of a Grand Design.
Well located. Reasonably priced. Potential to add value. Instagram worthy, the envy of their friends.
Then they filter the property listings by their budget. Stare in horror at the struggle-town locations or tiny shoeboxes they can actually afford. Shake their head in dismay.
A trade-off ensues.
Wait longer and save more.
Alternatively, compromise those dreams and settle for less. Much less.
Or perhaps purchase their desired lifestyle by increasing commuting times. Missing the irony that in doing so they will have less time to enjoy the quality of life they are attempting to buy. Not in the real world, where the pandemic induced promise of remote working by default has proven to have been nothing more than a rapidly fading fever dream.
Every property they enquire about is already under offer. A frothy market, demand exceeding supply.
Learning to respond to new listings with the speed and precision of a Formula 1 pit crew.
Investing less time viewing the property than they take to choose what to eat from a restaurant menu. Then making the largest purchasing decision of their lives based on that fleeting first impression.
Those scarce moments subjected to a monologue of pressure tactics from a smug estate agent. Queues of anxious buyers lined up. Racing against the twin threats of rising interest rates and rising house prices. Multiple offers already received. Competing against chain-free buyers backed by the bank of Mum and Dad, and cashed-up developers seeking their next renovation project.
Eventually, the property seeker may have an offer accepted.
Survive the gazumping gauntlet.
Get to the point where contracts are exchanged and financial obligations become inescapable.
Now the aspirational buyer has to come up with the money.
House deposit. Stamp duty. Legal fees. Bank fees.
Tens of thousands.
Hundreds of thousands.
There is just one problem. The markets have moved against them.
If their deposit had been held in cash, this wouldn’t matter. Observed with disinterest. Perhaps relief.
However, if they had stayed invested, the value of their portfolio in that moment may now be less than they had based their numbers on.
At the time of writing, the Hang Seng and S&P500 indexes were both down 12% year to date. The fall in the DAX, Nasdaq, Nikkei, and Bitcoin was closer to 15%. Ethereum and the MOEX Russian index had lost in the region of 30% of their value. Each a potentially pucker factor inducing reduction in wealth for that aspirational homeowner, who was banking on converting their portfolio into a house deposit.
Of course, the markets could just as easily have risen by 12% during that period. At which point the same homebuyer would be declaring themselves an investing genius with nerves of steel. Perhaps getting to purchase their house “for free”, as market gains rather than hard-earned savings provide all the equity they contribute to the deal.
Given the vast earnings multiples that housing located near decent employment prospects command, this liquidation timing question is a financial conundrum faced by many.
A real-world example of risk versus reward in action.
Next, consider the tax implications of that anticipated change in asset allocation.
With careful forethought and proper planning, any investments would have been held in accessible tax-advantaged accounts, such as stocks and shares ISAs.
But how many of us knew about tax advantaged accounts straight out of school?
By the time the novice investor had learned enough to know about ISAs, and earned enough to worry about legal tax avoidance, their investment holdings may have been compounding for years.
After the impressive bull run that global markets enjoyed in recent years, there is potentially a hefty accrued capital gains tax liability just waiting to be crystallised by an asset sale event. Up to 28% of those hard-won gains instantly evaporating at the decision to sell. Ouch!
Some aspirational homeowners may apply lateral thinking. Remembering that taxes are usually optional.
Some may elect to borrow against that taxable investment portfolio, rather than liquidating it.
No capital gains realised.
No taxes incurred.
From a cash flow perspective, a margin loan secured by an equities portfolio can incur lower financing costs than an equivalent sized interest-only variable rate mortgage.
But the two are not like-for-like propositions.
The asset securing a traditional mortgage is valued just once, at the inception of the loan. From that point onwards, buyer and lender mutually pretend the property will retain its value for the duration of the loan.
A margin loan is marked to market. Every day a nervous lender weighs up the value of the portfolio securing the loan against the size of the outstanding debt. When prices rise, everyone sleeps soundly. Should prices fall however, things may get exciting.
In reality, margin loans won’t work for the majority of homebuyers.
Loan to valuation ratios are capped at much lower levels than mortgages. Margin lenders start to get antsy if leverage levels climb above agreed levels, often lower than 50%. Which means that the taxable portfolio securing a margin loan would need to be worth at least double the amount that the aspirational buyer wished to borrow.
A tall order for someone who has been struggling to squirrel away their deposit!
So instead, the wannabe homeowner sells down their portfolio. Eating the fees. Taxes. Purchasing power erosion. And opportunity costs of foregone potential investment gains.
Using the net proceeds to buy themselves a home.
While the outcome is relatively certain, the timing of that move to cash is anything but. The correct answer only knowable in hindsight. Driven by a desire for peace of mind and financial certainty. A seldom discussed aspect of the buying process, but one that has potentially vast implications for the speed and growth trajectory of the homebuyer’s wealth.