Morningstar Advisor - Spring 2007 - 14

Gray Matters How Human Capital Changes a Portfolio’s Picture An investor who is a “bond” should increase the stock portion of his portfolio of financial assets. Age Without Human Capital With Human Capital Stocks Bonds Investor A 45 years old 40 60 100 Investor B 55 years old 60 40 35 65 of his financial assets in the stock market than the teacher, since the broker has implicitly invested his human capital in the stock market. Another case of high correlation between human capital and financial assets would include people who are heavily invested in their company stock. Human capital is already tied to the company and industry in which people work, but its correlation to their financial assets is magnified when the two converge (in the case of owning company stock). This convergence makes it difficult to achieve a target risk profile because the amount of financial assets available to balance human capital characteristics may be relatively small. Advisors should invest clients’ financial assets in a way that diversifies and balances out their human capital. Young investors with safe human capital assets should invest more financial assets into stocks than older investors. The portion of financial assets allocated to stocks should be reduced as the investor ages. The higher the risk of human capital, the smaller the allocation to stocks for the financial assets. High correlation of human capital and the stock market will also reduce the allocation to stocks for the financial assets. Today, individuals face a complex set of investment decisions that change throughout their lifecycle. Advisors should consider age, occupation, and education level in determining the human capital profile of their clients to provide valuable advice toward a more holistic approach to portfolio allocation. K Peng Chen, Ph.D, CFA, is president and chief investment officer of Ibbotson Associates Investor C 65 years old 75 25 75 25 dations that simply matched their risk-tolerance profiles. When human capital is considered, however, the picture changes. For example, 40% of Investor A’s total wealth is composed of financial assets; the remaining 60% of her wealth is her human capital. Let’s say her risk tolerance indicates that she should invest her total portfolio in 60% stocks and 40% bonds. Because she already has 60% of her total wealth (represented by her human capital) invested in “bonds,” Investor A should choose a 100% stock asset allocation for her financial assets. Investing 100% in stocks is the closest she can get her total portfolio to her target allocation. Investor A will need to keep putting financial assets into stocks until she meets her target. Investor B’s total wealth consists of 60% financial assets and 40% human capital. Based on his risk tolerance, his target allocation is 40% stocks and 60% bonds. Considering Investor B’s “bond-like” human capital, the asset allocation for his financial assets should be approximately 65% stocks and 35% bonds, thus matching the 40/60 target allocation for his total wealth. Investor C, 65, just retired. His total wealth is 100% financial assets and 0% human capital. His target allocation is 25% stocks and 75% bonds. Therefore, he should devote 25% of his financial assets to stocks and 75% to bonds. In the real world, of course, the risk and return characteristics of each individual’s human capital varies. In the above example, we assume that human capital is a 100% bond investment. In other words, we assume that the investor’s future labor income is certain and safe. Only a small portion of investors have this kind of safe human capital. Labor income is uncertain for most investors for a number of reasons, including the possibility of losing their jobs. The uncertainty in the labor income makes human capital a risky asset. For example, a business owner, a stock portfolio manager, stockbroker, and a tenured school teacher have very different risk profiles in their human capital. A broker’s human capital is far more sensitive to the stock markets than a school teacher’s. If a broker and a teacher have the same amount of total wealth and similar risk tolerances, human capital theory would recommend that the broker invest a smaller portion For more on human capital, download the author’s paper “Human Capital, Asset Allocation, and Life Insurance”at http://advisor.morningstar.com/uploaded/pdf/research.pdf. 14 Morningstar Advisor Spring 2007

http://advisor.morningstar.com/uploaded/pdf/research.pdf

Morningstar Advisor - Spring 2007

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