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 That can lead to taking on too much or too little risk, resulting in
higher volatility in wealth.
Adjust for human capital and other types of non-financial assets and
you will end up with a much different, and better mix based on your
particular situation.
“The average person left to their own devices is blind to the kind
of risk associated with human capital,” said David Blanchett, head
of retirement research at Morningstar Investments and co-author of a
paper in the May/June edition of Financial Analysts Journal.
The traditional approach to diversification concentrates on how the
performance and behavior of different types of financial assets can
interact within a portfolio. Hold bonds, for example, not because
you think they’ll outperform but because they serve as ballast,
steadying the portfolio and allowing an investor to take on more
risk and earn more reward than they might otherwise.
But to look at the risks and rewards of stocks, bonds and other
financial assets in isolation ignores the often greater assets and
more important risks that investors face. Economist Gary Becker
estimated that the value of human capital is at least four times
that of all stocks, bonds, housing and other assets combined. That
human capital, which in financial terms comprises our ability to
earn income, has a different value and different risks at different
points in our lives.
Take for example a 25-year-old. According to Blanchett and co-author
Philip Straehl, 94 percent of her total wealth on average is human
capital, and just 1 percent financial assets. Fast forward to the
age of 60 and the typical person’s wealth will be 20 percent
housing, 29 percent pensions (such as social security), 19 percent
financial assets and 31 percent human capital.
If your goal is lower volatility in total wealth, which is part of
the point of diversification, then it becomes important to adjust
where you put your money based on the value, and future value, of
your other forms of wealth.
A younger person, with more time to out-earn their mistakes, can
take on more equity risk than an older one, who has less potential
earnings in front of her, and less time to overcome career setbacks
such as layoffs. At the same time housing, financial and pension
wealth rises, offsetting some of the risk.
VOLATILE REAL ESTATE AND JOB MARKETS
The paper found that a 25-year-old’s optimal allocation is 61
percent equities, a figure that falls to 48 percent at 45 and just
26 percent at 65.
The total wealth approach to allocation led to an average annual
increase in risk-adjusted outperformance of 30 basis points annually
across the 1,000 scenarios studied, according to the study.
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Housing makes up an important part of most people’s wealth: a fifth
of the total wealth of the average 60-year-old. Housing too, as we
learned in the last decade, can be a volatile asset, especially
given that it is usually debt-financed, magnifying gains and losses.
The study looked at optimal allocations for home owners in 10 major
cities and found, unsurprisingly, that those who own real estate in
volatile places like Las Vegas or Miami should hold more cash and
more bonds.
People don’t just have jobs, they have jobs in industries, and for
good or ill, their future wage earning ability is tied to the
fortunes of that industry. The findings here too aren’t surprising:
work for the government and you can probably take on more investment
risk than if you work in hospitality or lodging.
While many advisors may take this into account, and some individuals
surely do, it is far from standard practice, and probably should be.
Going beyond this, it makes sense for workers in industries to vary
their allocations between equity sectors in order to diversify their
risks. Work in manufacturing? You probably should have some extra
commodities exposure as when raw materials go up in price your
industry does poorly. Work in mining? Don’t own mining stocks.
Much of this is what a good financial advisor should already be
doing - getting a feel for the totality of a client’s position and
making the needed adjustments.
It probably won’t be too long before robo-advisors begin to offer
adjustments based on these factors, even down to industry risk
profiles.
Human advisors would do well to get a head start.
(At the time of publication James Saft did not own any
directinvestments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund)
(Editing by James Dalgleish)
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