Do you have a high-risk, high-reward career? If you do, model portfolios marketed by fund companies may not be right for you.
Your most valuable asset
If you are younger than 60, chances are your most valuable asset is not your home, or stocks and bonds. It’s your human capital, that is, your ability to earn money using your knowledge, skills and physical labor. This human capital has characteristics that can be measured in the same terms as financial assets – it can be valued, it has a time horizon, it has a liquidity profile, and it is subject to risks (both predictable and unpredictable). It is the illiquidity of human capital that tends to separate it from most financial assets – human capital can generally be liquidated only one day at a time through work. While there are many creative compensation schemes out there, as a general rule you will not be paid for your future labor until you actually perform that labor.
How it adds up
To provide an example, a 37-year-old who expects to earn $250,000 from her job each year for the next 30 years would have human capital worth $3.8 million today (using a discount rate of 5%). Of course, few people earn exactly the same amount for 30 years. Our subject could die or become disabled during this period. She would likely earn raises or promotions in some years. There could be one or more period of unemployment. She could decide to change careers or retire earlier or later. While these assumptions about the future will significantly impact the value of our subject’s human capital, it is unlikely that she will possess financial assets in excess of the value of her human capital until she is much older (unless she receives an inheritance, is uncommonly frugal, or earns outsize investment returns).
Why you should care
Mainstream financial planners don’t explicitly consider human capital in advising their clients. While it is true that good comprehensive planners may implicitly consider human capital when, for example, assessing client’s readiness for retirement, imputing income fluctuations in setting budgets, recommending term life and disability insurance, etc., the characteristics of human capital rarely find their way into decisions related to the investment of financial assets. This is, in my view, a major failing of financial advisors who delegate investment management to outside parties, whether it be the advisor’s parent company, a third-party “turnkey” asset management provider, or robo-advice software. In all these cases, a third party provides a set of model portfolios that seek to optimize the allocation of the financial assets, without regard to what, for most clients, is their most valuable asset.
Prior to starting True Square Financial, I worked for a big mutual fund company. One of my responsibilities was to research and collaborate with robo-advisor firms. What I learned is that robo-advisors generally base their investment recommendations on the same two questions: 1) How close are you to retirement (or sometimes, another goal, like college)? and 2) How do you feel about risk on a scale of 1 to 10?. Then they use the answers to these two questions to assign clients to a model portfolio, typically from a menu of fewer than 10. That’s it. That’s the whole algorithm.
There are three main reasons why mainstream financial advisors do not advise clients more holistically. The first reason is risk management – large firms only allow advisors to consider the assets they have under management because they are not willing to accept the risk related to assets that they do not directly control. The second reason is efficiency – putting all clients in one of a few model portfolios is takes less work than creating and managing a unique portfolio for each client. The third reason is skill – by not asking advisors to deal with the nuances and fluctuations of clients’ careers, firms can hire less experienced advisors with narrower skill sets.
What to do differently
I recommend that clients consider the rewards, risks and liquidity of their financial assets in the broader context of the rewards, risks and liquidity of their human capital. For individuals with stable or consistently growing cash income, such as tenured university professors, federal judges, career civil servants, or senior airline pilots, a more aggressive allocation of financial investments would generally be appropriate. For individuals whose income is highly correlated with US equity markets, such as investment bankers, hedge fund managers, and corporate executives with significant holdings of company stock, a conservative or even counter-cyclical approach may be best. While this process may not be an exact science, it is far preferable to the simplistic one-size-fits-all approach that model portfolios are built on.
To be clear, I am not the first person to notice this or write about it. I have seen the topic discussed in wonky industry research papers
and in a recent mass market book.
However, I feel this shortcoming in our industry is at least as important as other issues that get far more press.
What do you think? How do you think about your financial investments in the context of your education, skills, and career choices? Please leave a comment below.