Morningstar Advisor - Spring 2007 - 13

A Working Life As an investor ages, she can expect the worth of her human capital to decline and her financial assets to appreciate as she saves and earns returns on her portfolio. Advisors should invest clients’ financial assets to balance out their human capital. $800,000 Human Capital $700,000 Assumptions • Income is $40,000 with a 10% savings rate • Investments grow at a real return rate of 5% annually Financial Capital $50,000 $0 25 yrs 30 35 40 45 50 55 60 65 capacity for risk. People with high earning abilities are able to take more risk, because they can easily recoup from financial losses. Earning ability is often referred to as an investor’s human capital. Although the impact of human capital on investors’ portfolio choices has been studied by many academic researchers, this concept has not been widely used in the management of the individual investor’s financial portfolio. Yet human capital is important for determining an appropriate asset allocation for an individual investor. Human capital is one of two parts of an investor’s total wealth; financial assets is the other. Human capital is defined as the present value of an investor’s future labor income. Although not tradable, it is often the single largest asset an investor has. Typically, young investors have far more human capital than financial capital. This is because young investors obviously have a long life of work ahead of them and they have had little time to save and accumulate financial wealth. It is quite reasonable for young people to put their financial wealth into an all-stock investment portfolio, because they could easily offset any disastrous returns in the short run through adjusting future investment strategy, consumption, and savings. On the other hand, older investors tend to have more of their wealth in financial capital than human capital, since they have less time to work but have saved and accumulated financial capital over a long career. Therefore, as people age and their time horizon shortens, their financial portfolio should become less aggressive. To fully understand the role human capital plays in portfolio building, however, we must take it a step further. Not only should advisors look at human capital as a component of wealth; they also should consider the risk and return characteristics of a client's human capital and its correlation to other assets in the person’s financial portfolio. By taking this step, advisors can create less-volatile, better-balanced portfolios over the client's lifetime. Let’s look at three investors: Investor A is 45 years old, Investor B is 55, and Investor C is 65. For this exercise, we’ll assume there are only two asset classes: stocks and bonds. Next, let's say that each investor is a tenured college professor and able to save a modest amount every year. Because their future income stream is fairly certain, we can classify their human capital as a bond investment. (If our investors were stockbrokers, their human capital would be highly correlated to a volatile asset class: the stock market. Therefore, we would classify their human capital as a stock.) Without considering human capital, each investor would receive the portfolio recommen- MorningstarAdvisor.com 13

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Morningstar Advisor - Spring 2007

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