Asset Allocation with a Human Capital Perspective
Financial Advisers traditionally look at Portfolio asset allocation as distribution of Funds between three main asset classes Equity, Bonds and other Alternative Assets. What is missed out is context of Human capital? What is it and how does it impact the portfolio?
What is asset allocation?
Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in the portfolio according to the risk tolerance, goals and time frame of the investor. As I had mentioned in my previous blog on IPS that Risk is an important factor to be considered while designing any Portfolio.
How is human capital relevant?
Human Capital is one of the important factors that define the individual’s ability and willingness to bear risk. To define, Human Capital is the present value of expected future income of the individual. The importance of Human capital is often underestimated. Let's take an example, If as an adviser you need to create a portfolio for two identical client except for, one who is a Full time Professor and other who is a Full time trader. And if a 50% Stock and 50 % Bond allocation is advised to both of them, do you feel we are on the right track? Is it going to have same impact on each one’s portfolio? No, it’s not going to be the same. The question is why, assuming both of them had invested in same portfolio. The reason is the Professor has more stable job then the full time trader. Let’s say we have a downfall in Equity Market, and equity portion of both the portfolio’s goes down. This Market downfall is going to have more adverse impact on individual working in Stock Market rather than the Professor. Not only the Traders portfolio value has gone down but due to the Market downfall his job is also going through the bad phase. This means that the Stock Trader when he required his portfolio to support him (during the downfall in his career) couldn't help him.
The reason is correlation, correlation between the nature of individual’s job (one’s labor income) and his portfolio, an important factor to be considered while designing any portfolio. If we fail to consider this, we are missing a very important part of Investment theory. When our perspective incorporates Human Capital we see the logic behind it. Some questions to ask when designing a portfolio:
- Why nature of job is important input of Asset Allocation?
- Why advice on asset allocation varies with Age?
- Why old people are advised to invest more in bond and young people are advised to invest more in equities?
The reason being, young people have more human capital than the aging generation. Young people have more time and so more ability to bear risk of in case of market downfall.
The conclusion being:
- Investor with safe labor income (thus safe Human Capital) will invest more of their financial portfolio in equities.
- Investor with labor income that is highly positively correlated with stock market should tend to choose an asset allocation with less exposure to stocks.
- The allocation to stock should decrease as investor ages.
So, next time when ever we design our Investment Portfolio or have an adviser to do so, make sure he understands your nature of job and accordingly designs your Portfolio. Happy Investing.