While the evidence we have examined so far is consistent with portfolio theory, one interesting conflict deserves mention: While investors seem to follow portfolio theory, hedging their labor capital by shifting their stock holdings as the volatility of their labor capital changes, they ignore theory completely in another way.
Studies have found that households tend to hold stocks that are closely related to their labor income, especially the stock of their employer. This is contrary to the hypothesis of hedging labor income risk. It seems that the familiarity bias is too hard to overcome for most investors.
Hopefully, you’re following the example of Swedish workers, incorporating labor capital risk into your investment plan. However, if your plan doesn’t incorporate your labor capital, you should reconsider your asset allocation by taking it into account.
If you’ve made the mistake of playing the game of “double jeopardy,” investing in the stock of your employer, it’s a mistake you should correct as soon as possible. And if you’ve changed jobs since your plan was created, altering the volatility of your labor capital, you should revisit your plan.
Finally, if you don’t yet have a plan, the very next thing you should do is create one. While you can get rich buying lottery tickets, it’s not likely. It’s also not likely you’ll achieve your financial and life goals without an investment plan. As Yogi Berra reportedly said: “We’re making great time, but we’re lost.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.