Constructing a portfolio based only on how financial assets will perform and behave ignores many of the investor’s biggest assets: earning power, real estate and pension benefits such as social security.
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 behaviour 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 Straeh, 94% of her total wealth on average is human capital, and just 1% financial assets. Fast forward to the age of 60 and the typical person’s wealth will be 20% housing, 29% pensions (such as social security), 19% financial assets and 31% 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% equities, a figure that falls to 48% at 45 and just 26% at 65.
The total wealth approach to allocation led to an average annual increase in risk-adjusted outperformance of 30bp annually across the 1,000 scenarios studied, according to the study.
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.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
