Swedroe: Understanding Different Types Of Risk

April 12, 2017

The second point is that we need to not only consider the magnitude of our human capital but also its volatility. Some people (such as tenured professors, doctors and government employees) have stable jobs, and thus their labor income is almost like an inflation-indexed annuity. In other words, it acts very much like a bond. Other people (such as commissioned salespeople and construction workers) have labor income that is more volatile, and thus acts more like equities. Financial advice should incorporate these differences.

For example, for people with safer labor income, it might be appropriate to invest more aggressively—with a higher allocation to equities overall and perhaps higher allocations to riskier small and value stocks. Those with riskier labor income should consider holding less aggressive portfolios (those with higher bond allocations).

This gets to the heart of Markowitz’s work on portfolio theory: An asset shouldn’t be considered in isolation. Note there may be times when the riskiness of one’s human capital changes (after a career change, for example). If the riskiness of the human capital increases, one should consider reducing the riskiness of the other assets in the portfolio, and vice versa.

A related issue is the significance of human capital as a percentage of total assets. If human capital is a small percentage of the total portfolio (because there are large financial assets), the volatility of the human capital and its correlation to financial assets becomes less of an issue.

Correlation, Health And Mortality

The third point we need to consider involves one of the most basic principles of investing—don’t put too many eggs in one basket. Individuals should avoid investing in assets that have a high correlation with their human capital. Unfortunately, far too many people follow Peter Lynch’s advice to “buy what you know.” The result is that they invest heavily in the stocks of their employers.

This is a mistake on two fronts. The first is that it’s a highly undiversified investment. The second is that the investment is likely to have a high correlation with the person’s human capital. Employees of such companies as Enron and WorldCom found out how costly a mistake that can be.   

The fourth point to consider is that human capital can be lost due to two risks that need to be addressed by means other than through investments. The first is the risk of disability. This risk can be addressed by the purchase of disability insurance. Thus, the risk of disability and how to address it should be part of the overall financial plan. The other risk is that of mortality. That issue can be addressed by the purchase of life insurance (we will discuss that in more detail).

There are still other points to consider. All else being equal, people with a high earning capability have a greater ability to take more financial risk because they can more easily recover from losses. However, they also have a lower need to take risk. All else being equal, the higher their earnings, the lower the rate of return they need from their investment portfolio to achieve their financial goals—they can choose less risky investments and still achieve them. 

 

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