Harry Markowitz received the Nobel Prize in Economic Sciences in 1990 for his contributions to the body of work known as “modern portfolio theory.” Probably his greatest contribution was to turn the focus away from analyzing the risk and expected return of individual investments to considering how its addition impacts the risk and expected return of the overall portfolio.
Markowitz showed it was possible to add risky assets (with low or negative correlation) to a portfolio, increasing the expected return without increasing overall risk. He also demonstrated the importance of diversification of risk.
Today most investment advice focuses on the development of portfolios that are on the “efficient frontier.” A portfolio that is on the efficient frontier is one in which no added diversification can lower the portfolio’s risk for a given return expectation (alternately, no additional expected return can be gained without increasing the risk of the portfolio).
Working with the efficient frontier, investment advisors tailor portfolios to the individual investor’s unique situation. Unfortunately, far too many investors and/or their advisors only focus on the risks of the investments themselves.
Managing Financial, Not Just Investment, Risks
When developing an overall financial plan, there are risks—other than investment risks—that are important to consider. Not integrating the management of these risks into an overall financial plan can cause even the most carefully considered and well-thought-out investment plans to fail. Among the other risks that should be considered are human capital (wage-earning) risk, mortality risk and longevity risk. Let’s consider how these risks should be integrated into an overall financial plan.
Human Capital Risk
We can define human capital as the present value of future income derived from labor. It’s an asset that doesn’t appear on any balance sheet. It’s also an asset that is not tradable like a stock or a bond. Thus, it’s often ignored, at potentially great risk to the individual’s financial goals. How should human capital impact investment decisions?
The first point to consider is that, when we are young, human capital is at its highest point. It’s also often the largest asset young individuals have. As we age and accumulate financial assets, and our time remaining in the labor force decreases, the amount of human capital relative to financial assets shrinks. This shift over time should be considered in terms of the asset allocation decision.