Asset Allocation With Yourself As a Factor

From “No Portfolio Is an Island” by David M. Blanchett and Philip U. Straehl, (FAJ Vol 71 No 3 2015)

When building portfolios, most investors tend to focus entirely on the risk and return characteristics of investments, such as cash, bonds and stocks, ignoring the interconnectedness of their portfolios with other assets that they effectively own, such as human capital, real estate, and pensions. In many instances, these overlooked assets’ value exceeds the value of the financial (i.e. liquid) wealth. For example, Becker (1993) estimated that the value of human capital is at least four times larger than the value of stocks, bonds, housing, and all other assets combined. Heaton and Lucas (2000) estimated that human capital is 48% of household wealth whereas financial assets represent only 6.8%.

In the study, they found ‘significant evidence that the optimal allocation for an investor’s financial assets varies materially for different compositions of total wealth’.

Even more interesting is their finding that what one does for a living, your ‘industry-specific human capital’, a non-tradable asset, does matter. Optimal equity allocation is higher for a worker in an industry with a lower equity market beta. For example, if you work for the government with bond-like compensations, then your optimal allocation would be to hold more equity. In terms of mitigating risks associated with human capital, quasi hedge is available in the form of unemployment insurance, disability insurance, and life insurance.

Although here is where I depart slightly in agreement, because the suggestion below does not consider inter-generational wealth, for example, if investors are concerned with building wealth for their descendants.

This research suggests that equity allocations should change over time as human capital is consumed (or depleted), taking the shape of a “guide path” that is common in target-date investments today.

The common, current wisdom is for investors to shift more to bonds as they near retirement. While on the surface it does make sense, this advice does not take into account of the idiosyncratic risk borne by bonds.

Another form of wealth is pension wealth. For many, this income stream is fixed and guaranteed by the government. In the US, pensions represent a significant asset for many, especially for older folks.

9 out of 10 people age 65 and older receive Social Security benefits, and the average monthly benefit is $1,269 (based on data from the Social Security Administration website). And among elderly Social Security beneficiaries, 53% of married couples and 74% of unmarried persons receive at least 50% of their income from Social Security.

Of course, pension benefits relate to wages and what you did before you retired. In addition, as Greek pensioners found out, to completely rely on one source or one type of income might not be a good idea.

What about the house that you’ve bought? Housing wealth needs to be taken into account too. As the price of your house is positively correlated to local securities, this study recommends that you underweight those local securities.

The take-away from this post is that as an investor, you are exposed to risks beyond your financial asset, i.e. your portfolio. It is worth bearing in mind your total wealth when designing your investments, at which stage you are in your life, and how your human capital factors in the whole mix.

Thus, the trends for an average investor found from the study can be summed as follows:

1. Human capital is likely to be dominant asset for younger people, those in their 20s and 30s.

2. The relative value of pensions increases as a person nears retirement.

3. Financial assets are likely to be at their largest at retirement.

4. The relative value of real estate is likely to increase over a person’s lifetime, assuming housing wealth is not used to fund retirement.


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