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.
First, shorting wasn’t allowed. Second, the maximum allocation to a single asset class was 20 percent, thus ensuring the portfolio has allocations to at least five asset classes. Third, the return on the financial assets had to equal the average quarterly return on all available asset classes over the study period (2.05 percent). The third constraint ensured that the resulting allocations were at least somewhat balanced across the asset classes.
To incorporate human capital, the authors determined the value of that capital by assessing growth and discount rates specific to 10 different industries.
Following is a summary of their findings:
- There’s significant evidence that the optimal allocation for an investor’s financial assets varies materially for different compositions of total wealth.
- While human capital is generally positively correlated with financial assets (the average correlation is 0.27), correlations vary materially across industries. Thus, the optimal portfolio varies significantly for different types of industry-specific human capital. The optimal equity allocation is higher (lower) for a worker in an industry with a lower (higher) equity market beta. The issue of labor capital stability and its correlation with equity risk, and how that should impact your equity allocation, is discussed in my book, “The Only Guide You’ll Ever Need for the Right Financial Plan,” which I co-authored with two colleagues.
- Human capital is correlated with the value factor.
- For a given level of risk aversion, investors should consider both the relative weight of their human capital and other outside wealth as a percentage of total wealth as well as the difference in the riskiness of their human capital and other outside wealth.
- While including housing wealth has a smaller impact on portfolio optimization results than the inclusion of human capital, housing wealth does still have a material effect. In general, region-specific housing wealth portfolios have higher allocations to small value and, as you would expect, lower allocations to REITs.
- A region-specific housing portfolio should underweight (overweight) assets that have a high (low) correlation with region-specific housing wealth. If housing prices are correlated with the value of the stocks of local companies, you would want to underweight those stocks.
- On average, the optimal equity allocation decreases from 61 percent at age 25 to 26 percent at age 65 as an individual’s human capital erodes, and housing wealth and financial wealth rise.
- While those whose total wealth is dominated by nonfinancial assets—such as human capital—have the most to gain from a total wealth approach to portfolio optimization, incorporating outside wealth results in an average increase in risk-adjusted return of 30 basis points.
The authors’ findings demonstrate the importance of taking a total wealth approach to financial planning and the construction of a truly efficient portfolio. While incorporating the authors’ findings isn’t simple, that does not make this task any less important.
“The Only Guide You’ll Ever Need for the Right Financial Plan” provides investors as well as advisors with key questions to ask when choosing the most appropriate asset allocation. It also provides specific examples and directional recommendations on how to incorporate the important issues discussed in this paper.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.