When designing an investment plan and deciding on the appropriate asset allocation, you should make sure to consider your unique ability, willingness and need to take risk. The latter two considerations are fairly straightforward. The more “stomach acid” you can absorb during bear markets without abandoning your plan, the higher your allocation to stocks can be. And the higher the rate of return you need to meet your financial goals (and the more you convert desires into needs), the higher your allocation to stocks must be.
When thinking about their ability to take risk, most investors focus on their investment horizon—the longer the horizon, the greater the ability to take risk and the higher allocation can be to riskier stocks. However, the issue is more complex.
As I discuss in “The Only Guide You’ll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments,” an investor’s ability to take risk is determined by not only their investment horizon, but their need for liquidity.
Another determinant is whether they have options that can be exercised should bear markets create a need to implement a “Plan B” (such as cutting spending, working longer, lowering the goal) that would prevent the portfolio from “failing” (leaving the investor without assets sufficient to meet their needs). However, there is a fourth factor impacting the ability to take risk: one that is often overlooked even by many advisors—the stability of one’s human (labor) capital.
Human Capital: A Definition
We can define “human capital” as the total value of an individual’s labor. It’s a unique asset because it varies by age, health, education, occupation, industry and experience, among other variables, and is nontradable and difficult to insure/hedge. The greater the stability of human capital (earned income), the greater the ability to assume the risks of owning stocks.
For example, a tenured professor has a greater ability to take risk than either a worker in a highly cyclical industry where layoffs are common or an entrepreneur who owns a business with cyclical earnings.
The reason is that the tenured professor’s earned income has bondlike characteristics. All other things being equal, she has a greater ability to hold stocks. The entrepreneur’s earned income has equitylike characteristics, so he should hold more bonds. In other words, investors should ask themselves, “Am I a stock or a bond?”
Since labor income accounts for about two-thirds of national income in the U.S., it should play an important role in determining asset allocations for most people. David Blanchett and Philip Straehl contribute to the literature on human capital with their paper, “Portfolio Implications of Job-Specific Human Capital Risk,” which appears in the January 2017 issue of the Journal of Asset Management.
Their paper explores human capital risk at the level of industry-speciﬁc jobs. They control for both industry and occupation to measure the impacts of each on human capital risk. Their data sample covers the period 2003 through 2014 and uses Bureau of Labor statistics on 23 industries and 22 occupations.
Following is a summary of their findings:
- Human capital is generally 30% stocklike, although signiﬁcant differences exist across industries and occupations. For example, government industry has a market beta of 0.00, while mining has a market beta of 0.53. In addition, different industries/occupations have different exposures to the size and value factors.
- Volatility associated with a job is much greater than volatility associated with a given industry or occupation.
- Industry and occupation factors in isolation are about equally important, while job-speciﬁc factors (deﬁned as the unique combination of an occupation within a given industry) account for the majority of human capital variance.
- Human capital beta—or the extent that human capital risk is correlated to the equity market—is the primary determinant of difference in the optimal equity weights at the aggregate level.
- Market and nonmarket factors play important roles at the individual job level.
- Investors in jobs with high wage volatility that is unrelated to market factors face a lower capacity to take on risk.
As an example of the impact of human capital on portfolio design in an optimization, Blanchett and Straehl found that the spread between the industries with the highest and lowest equity allocation was 35.5 percentage points.
Not surprisingly, the government sector has the highest equity allocation—76%—given its market beta of zero and a low overall variance of human capital. Conversely, mining has the lowest equity allocation—40%—given its high market beta of 0.53.
Blanchett and Straehl concluded: “We ﬁnd signiﬁcant evidence that job-speciﬁc human capital differences have a material impact on the optimal portfolio and should therefore be considered during the portfolio optimization/construction process.”
This is important because human capital is a dominant asset for many investors, and unlike the risks of individual stocks, it is a risk that cannot be diversiﬁed away and is difficult to insure/hedge. This highlights the importance of including human capital risk in portfolio design.
Do Investors Consider Human Capital: The Evidence
Sebastien Betermier, Thomas Jansson, Christine Parlour and Johan Walden, authors of the study “Hedging Labor Income Risk,” which appears in the September 2012 issue of the Journal of Financial Economics, attempted to determine if investors were actually incorporating sound portfolio theory into practice.
They used a detailed panel data set of Swedish households to investigate the relationship between labor income risk and investment decisions. In particular, they examined whether changes in the wage volatility of households (as workers switched industries) led to changes in portfolio holdings. Following is a summary of their findings:
- Households do adjust their portfolio holdings when switching jobs, consistent with the idea that households hedge their human capital risk in the stock market.
- The effect, which is highly statistically significant, is especially strong for job changes that lead to large changes in wage volatility: A household that experiences an increase in wage volatility of 20% decreases its portfolio share of risky assets by 20%.
- A household going from the industry with the least variable wage to the industry with the most variable wage (all else equal) decreases its share of risky assets by up to 35%, corresponding to the workers’ hedging demand for aggregate labor capital risk.
- These findings are consistent with prior research, which found evidence that households that expect high future wage volatility hold relatively low shares of risky assets.
The authors also found that an increase in net worth leads to a significant decrease in the allocation to risky assets. This too is logical, as increases in net worth lead to reductions in the need to take risk. In addition, while more wealth is always better than less, the marginal utility of wealth declines as wealth increases (at some point you determine you have enough, and it’s not worth the risk to try to create more). The study illustrates the Swedish investors acting rationally, putting portfolio theory to work.
Sebastien Betermier, Laurent Calvet and Paolo Sodini contributed to the literature on human capital and investments with their study, “Who Are the Value and Growth Investors?”, which appears in the February 2017 issue of The Journal of Finance. Their paper investigated value and growth investing among Swedish residents over the period 1999 through 2007. Among their findings were that:
- Households are not heavily tilted toward stocks in their employment sector, with the average direct stockholder allocating 16% of the stock portfolio to professionally close companies.
- Value investors are substantially older, are more likely to be female, have higher financial and real estate wealth, and have lower leverage, income risk and human capital than average growth investors—those with high human capital and high exposure to macroeconomic risk, who tilt their portfolios away from value.
- Over the life cycle, households progressively shift from growth to value as they become older and their balance sheets improve, with 60% of the increasing exposure to value explained by changes in age, 20% by changes in the balance sheet and 20% by changes in human capital.
- Households with high financial wealth, low debt and low background risk tend to invest their financial wealth aggressively in risky assets and select risky portfolios with a value tilt.
- Households with high current income and high human capital tilt their financial portfolios toward growth stocks. So do those with high income volatility and a self-employed or unemployed head of household. Further, households working in cyclical sectors tend to reduce their portfolio value tilts.
While the evidence we have examined so far is consistent with portfolio theory, one interesting conflict deserves mention: While investors seem to follow portfolio theory, hedging their labor capital by shifting their stock holdings as the volatility of their labor capital changes, they ignore theory completely in another way.
Studies have found that households tend to hold stocks that are closely related to their labor income, especially the stock of their employer. This is contrary to the hypothesis of hedging labor income risk. It seems that the familiarity bias is too hard to overcome for most investors.
Hopefully, you’re following the example of Swedish workers, incorporating labor capital risk into your investment plan. However, if your plan doesn’t incorporate your labor capital, you should reconsider your asset allocation by taking it into account.
If you’ve made the mistake of playing the game of “double jeopardy,” investing in the stock of your employer, it’s a mistake you should correct as soon as possible. And if you’ve changed jobs since your plan was created, altering the volatility of your labor capital, you should revisit your plan.
Finally, if you don’t yet have a plan, the very next thing you should do is create one. While you can get rich buying lottery tickets, it’s not likely. It’s also not likely you’ll achieve your financial and life goals without an investment plan. As Yogi Berra reportedly said: “We’re making great time, but we’re lost.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.
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