the important asset that many fail to consider in portfolio construction/allocation

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larryswedroe
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the important asset that many fail to consider in portfolio construction/allocation

Post by larryswedroe » Mon Mar 20, 2017 8:35 am

http://www.etf.com/sections/index-investor-corner/swedroe-factor-human-capital-your-financial-plans

For many, particularly younger investors, human capital is their largest asset, yet so many fail to consider it's role in the portfolio, failing to ask the important question, Am I a stock or a bond?

hope this is helpful
Larry

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nedsaid
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Re: the important asset that many fail to consider in portfolio construction/allocation

Post by nedsaid » Mon Mar 20, 2017 10:11 am

Volatility within industries is a big factor in determining human capital. I think of the people I knew at Hewlett-Packard which was a relatively stable company within the high tech industry. It was not unusual for someone in high tech to have worked for five or six different companies. Alas, even Hewlett-Packard changed and now they are more like the rest of the industry. If you work in such an industry and make very good money, be sure and be a diligent saver. Things change fast and when you get near or in your fifties, your human capital within that industry may evaporate. In other words, the great money may not last.
A fool and his money are good for business.

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Re: the important asset that many fail to consider in portfolio construction/allocation

Post by larryswedroe » Mon Mar 20, 2017 10:13 am

nedsaid
I've been really surprised at how few even financial advisors even ask this question in their portfolio construction for clients. For example, was while ago but someone told me they went through Vanguard's financial advisory service and they did not ask about the stability of labor capital. Perhaps that's not the case today, don't know. This is one of the many questions posed in The Only Guide You'll Ever Need for the Right Financial Plan

Larry

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nedsaid
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Re: the important asset that many fail to consider in portfolio construction/allocation

Post by nedsaid » Mon Mar 20, 2017 10:19 am

This issue became crystal clear to me a couple of years ago. My long time employer consolidated their finance teams and laid a bunch of us off in 2014. The finance function was centralized and I just learned that there was recently yet another round of layoffs there just recently. Good thing I didn't tie my life into knots to move to the new location, I would have likely moved to have been laid off again.

Since then, I have done a combination of contract and seasonal work along with unemployment. Haven't had to dip into savings very much for which I am thankful. I am very and painfully aware of this issue at age 57.
A fool and his money are good for business.

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Re: the important asset that many fail to consider in portfolio construction/allocation

Post by aj44 » Mon Mar 20, 2017 10:29 am

Excellent article, this is something I took into account when deciding to go with 120-age in stock. My wife and I also only allow lifestyle creep to grow with one of our incomes after 401k max, if one of us lost our jobs nothing in our budget/asset allocation needs changed.

I have also kept this in mind with my career, I have changed roles within different companies to gather more experience and to make myself more valuable. We also have saved enough to hit our number at 50 if that fails.

*3!4!/5!
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Re: the important asset that many fail to consider in portfolio construction/allocation

Post by *3!4!/5! » Mon Mar 20, 2017 4:53 pm

Strongly agree with this. Basically:

[Constant asset allocation] minus [human capital (and some other big stuff)] equals [glide path]

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Re: the important asset that many fail to consider in portfolio construction/allocation

Post by CurlyDave » Tue Mar 21, 2017 1:16 am

I had to deal with the human capital question when my employment became insecure due to office politics.

Personally, I decided that the best way to deal with this was to develop a paying sideline in my spare time. I started buying and improving rental real estate, which had a couple of interesting consequences. I immediately had a plan B if things got really bad, because I made a rule that I would never buy anyplace I would not live in if push came to shove. Over time the real estate investments started producing spendable income. Returns were better than in equities, partly because I bought properties I could put sweat equity into -- essentially I was trading my labor and some savings for increased property value and eventually spendable cash flow.

The results were amazing. At my primary employment I worked less, but produced more value. Because I had a viable plan B, I was not afraid to tell management when I felt they were going in the wrong direction. Doing this with respect instead of confrontation will usually result in greater respect in any job. This produced greater pay and job security. And, the real estate did well also.

Don't let anyone tell you differently, rental real estate is a part-time job. But it was one i owned. I couldn't be fired, and when it was time to retire, I could 1031 exchange it into one at my new location.

Building up a side business is a great way to use the human capital you have.

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Re: the important asset that many fail to consider in portfolio construction/allocation

Post by anoop » Tue Mar 21, 2017 1:24 am

The two biggest unknowns for me with financial planning are health followed by employability. I have seen enough instability in both areas to know that financial planning for me is really a coin toss. There is no way I can plan for every possible outcome. I am always amazed by, and perhaps a little envious of, people who can plan and execute their life path with clock-like precision.

I should mention that Worry Free Investing by Zvi Bodie first got me thinking about this several years ago. In that book he said one shouldn't be in stocks if one's employability depends on the stock market doing well, something which is true for a good chunk of the population. Because they will see their portfolio tank at the same time that they are also seeing their paycheck go away.
Last edited by anoop on Tue Mar 21, 2017 1:45 am, edited 1 time in total.

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Re: the important asset that many fail to consider in portfolio construction/allocation

Post by Noobvestor » Tue Mar 21, 2017 1:40 am

I dunno ... in theory, I could work for a long time and make a lot of money (high human cap), but I've also considered retiring early (low human cap). I guess it's an easier calculation for someone who just assumes they're going to work until X age. For me it's uncertain - I like working, but if I stop liking it, I'm not really sure what I'll be 'worth' in human cap terms going forward.
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Re: the important asset that many fail to consider in portfolio construction/allocation

Post by betablocker » Tue Mar 21, 2017 12:03 pm

I think this is a particularly important point for business owners who are exposed to both the income and equity risk of their businesses. Most do not factor in that private equity and end up doubling down on risk.

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Re: the important asset that many fail to consider in portfolio construction/allocation

Post by Random Walker » Fri Mar 24, 2017 7:22 pm

I'm currently rereading William Bernstein's Rational Expectations. He discusses thinking in terms of one's ratio of Human Capital to Investment Capital, where human capital is our future income and savings. As we age, the HC/IC ratio shrinks tremendously. His main point is that as that ratio shrinks, stocks become much more risky! A young accumulator is blessed by a big market downturn and a pre or early retiree could get slaughtered by big downturn. I find it very useful to think in terms of the HC/IC ratio for setting asset allocation.

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Re: the important asset that many fail to consider in portfolio construction/allocation

Post by KlangFool » Fri Mar 24, 2017 8:02 pm

Larry,

Great article!! Too many people think that they can go 100/0 without thinking about their job security. Then again, in some cases, the whole industry that was stable can go to hell in 5 to 10 years. So, people should not be so sure that their jobs are stable.

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Re: the important asset that many fail to consider in portfolio construction/allocation

Post by afan » Sat Mar 25, 2017 8:00 am

Great article. It raises one issue with which I have wrestled for a while. As net worth increases the marginally utility of wealth decreases. This argues against an aggressive investment posture since there is reduced need for growth. On the other hand, the higher net worth implies a higher ability to take risk.

Look at this on an "all things equal" basis. Assume the human capital risk is constant. If the investor is looking at long term growth, how to balance the lower need to take risk against the higher ability to do so?
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

Random Walker
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Re: the important asset that many fail to consider in portfolio construction/allocation

Post by Random Walker » Sat Mar 25, 2017 9:52 am

A fan,
Regarding the issue of decreased need to take risk versus increased ability to take risk, I'd say if investing for yourself let decreased need take precedence. If investing for next generation/legacy, then maybe let ability take precedence. As I said above, I've really been enlightened by Bernstein's discussion of the ratio of human capital to investment capital. As we age, human capital decreases and investment capital increases; thus making stocks much more risky as we age.
I'm also a big fan of the mind experiment comparing increased happiness of double wealth compared to decreased happiness of cutting wealth in half.

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Re: the important asset that many fail to consider in portfolio construction/allocation

Post by KlangFool » Sat Mar 25, 2017 10:08 am

afan wrote:Great article. It raises one issue with which I have wrestled for a while. As net worth increases the marginally utility of wealth decreases. This argues against an aggressive investment posture since there is reduced need for growth. On the other hand, the higher net worth implies a higher ability to take risk.

Look at this on an "all things equal" basis. Assume the human capital risk is constant. If the investor is looking at long term growth, how to balance the lower need to take risk against the higher ability to do so?


afan,

<< Assume the human capital risk is constant.>>

Human capital cannot be constant. As a person gets older, a person has less time to work and earn money. For example, assuming a life expectancy of 75 years, even for a person with perfect job security, that person has more human capital at 30 years old than at 40 years old. The difference is 10 years of human capital.

If human capital is not constant, then, the human capital risk to the overall wealth cannot be constant either.

<< long term growth>>

Ditto, the time for long-term growth changes as a person gets older. Some person at 30 years old has more time than a person at 40 years assuming they are at the same level of job security.

In summary, unless a person qualifies for some kind of pension, the ability to take risk goes down as a person gets older. Time had running out for the older folks.

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Re: the important asset that many fail to consider in portfolio construction/allocation

Post by afan » Sun Mar 26, 2017 10:33 am

Not "constant over time" but "constant across the range of assumptions".

Similarly, for "long term", assume the investment horizon does not change significantly as the investor ages. Say the ultimate beneficiaries will be great grandchildren. The children of grandchildren who themselves have yet to be born.

Assume grandparents will pay educational costs for grandchildren anyway and that we have a separate fund for great grandchildren's education. Say we are discussing extra money beyond that. Look at it as a retirement fund for great grandchildren who will be born 40 years from now and retire 110 years from now. I.e. "long term".
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

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