One of the more common investment mistakes that individual investors—and sometimes even professional advisors—make when they’re developing a comprehensive financial plan is failing to account for important nonfinancial assets.
Financial assets are easily observable and typically liquid. Thus, they’re often the center of attention. On the other hand, assets such as labor capital (the mortality-weighted net present value of future expected labor income), personal housing and pensions (the present value of future Social Security benefits and other pension benefits) are often overlooked.
Labor capital and pensions can go unnoticed because they don’t appear on any balance sheet and it can be difficult to measure their value. Furthermore, in most cases, they’re illiquid.
Typically, labor capital is at its peak when we are about to enter the workforce. It then falls as we age. Financial assets (such as stocks and bonds) and the value of housing assets, on the other hand, are normally at their lowest point earlier in our investing career. They tend to increase as we age. Both financial and pension assets are generally at their greatest value on the day we retire. And assuming housing wealth is not used to fund retirement, the relative value of real estate is likely to grow during a person’s lifetime.
How these types of assets—and their risks—mix in a portfolio is an important, but often ignored, issue. One apparently obvious conclusion is that, as we age and our labor capital is consumed, equity capital should be reduced (in a manner consistent with the glide paths of target-date funds).
Considering All Factors
Morningstar’s David Blanchett and Philip Straehl—authors of the study “No Portfolio Is an Island,” which was published in the May/June 2015 issue of Financial Analysts Journal—explored the impact of incorporating human capital, pensions and housing wealth into portfolio decisions.
The study covers the period beginning in 1993 and includes 13 asset classes: cash, U.S. and international nominal bonds (both intermediate- and long-term), TIPS, high-yield bonds, commodities, various U.S. equity asset classes, international stocks and REITs.
Using a nonlinear optimization routine, the authors’ objective was to minimize the variance of inflation-adjusted change in an investor’s total wealth. For their optimization, they adjusted only the weights to the financial assets, because all other types of wealth are considered nontradable.
Blanchett and Straehl placed three constraints on their optimization to reflect common investor considerations and to more easily isolate the differences that result from holding different amounts and types of wealth.