Swedroe: Factor Human Capital Into Your Financial Plans

March 20, 2017

When designing an investment plan and deciding on the appropriate asset allocation, you should make sure to consider your unique ability, willingness and need to take risk. The latter two considerations are fairly straightforward. The more “stomach acid” you can absorb during bear markets without abandoning your plan, the higher your allocation to stocks can be. And the higher the rate of return you need to meet your financial goals (and the more you convert desires into needs), the higher your allocation to stocks must be.

When thinking about their ability to take risk, most investors focus on their investment horizon—the longer the horizon, the greater the ability to take risk and the higher allocation can be to riskier stocks. However, the issue is more complex.

As I discuss in “The Only Guide You’ll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments,” an investor’s ability to take risk is determined by not only their investment horizon, but their need for liquidity.

Another determinant is whether they have options that can be exercised should bear markets create a need to implement a “Plan B” (such as cutting spending, working longer, lowering the goal) that would prevent the portfolio from “failing” (leaving the investor without assets sufficient to meet their needs). However, there is a fourth factor impacting the ability to take risk: one that is often overlooked even by many advisors—the stability of one’s human (labor) capital.

Human Capital: A Definition
We can define “human capital” as the total value of an individual’s labor. It’s a unique asset because it varies by age, health, education, occupation, industry and experience, among other variables, and is nontradable and difficult to insure/hedge. The greater the stability of human capital (earned income), the greater the ability to assume the risks of owning stocks.

For example, a tenured professor has a greater ability to take risk than either a worker in a highly cyclical industry where layoffs are common or an entrepreneur who owns a business with cyclical earnings.

The reason is that the tenured professor’s earned income has bondlike characteristics. All other things being equal, she has a greater ability to hold stocks. The entrepreneur’s earned income has equitylike characteristics, so he should hold more bonds. In other words, investors should ask themselves, “Am I a stock or a bond?”

Since labor income accounts for about two-thirds of national income in the U.S., it should play an important role in determining asset allocations for most people. David Blanchett and Philip Straehl contribute to the literature on human capital with their paper, “Portfolio Implications of Job-Specific Human Capital Risk,” which appears in the January 2017 issue of the Journal of Asset Management.

Their paper explores human capital risk at the level of industry-specific jobs. They control for both industry and occupation to measure the impacts of each on human capital risk. Their data sample covers the period 2003 through 2014 and uses Bureau of Labor statistics on 23 industries and 22 occupations.

Following is a summary of their findings:

 

Find your next ETF

CLEAR FILTER