Understanding Different Types of Risks
Harry Markowitz received the Nobel Prize in Economic Sciences in 1990 for his contributions to the body of work known as “modern portfolio theory.” Probably his greatest contribution was to turn the focus away from analyzing the risk and expected return of individual investments to considering how its addition impacts the risk and expected return of the overall portfolio.
Markowitz showed it was possible to add risky assets (with low or negative correlation) to a portfolio, increasing the expected return without increasing overall risk. He also demonstrated the importance of diversification of risk.
Today most investment advice focuses on the development of portfolios that are on the “efficient frontier.” A portfolio that is on the efficient frontier is one in which no added diversification can lower the portfolio’s risk for a given return expectation (alternately, no additional expected return can be gained without increasing the risk of the portfolio).
Working with the efficient frontier, investment advisors tailor portfolios to the individual investor’s unique situation. Unfortunately, far too many investors and/or their advisors only focus on the risks of the investments themselves.
Managing Financial, Not Just Investment, Risks
When developing an overall financial plan, there are risks—other than investment risks—that are important to consider. Not integrating the management of these risks into an overall financial plan can cause even the most carefully considered and well-thought-out investment plans to fail. Among the other risks that should be considered are human capital (wage-earning) risk, mortality risk and longevity risk. Let’s consider how these risks should be integrated into an overall financial plan.
Human Capital Risk
We can define human capital as the present value of future income derived from labor. It’s an asset that doesn’t appear on any balance sheet. It’s also an asset that is not tradable like a stock or a bond. Thus, it’s often ignored, at potentially great risk to the individual’s financial goals. How should human capital impact investment decisions?
The first point to consider is that, when we are young, human capital is at its highest point. It’s also often the largest asset young individuals have. As we age and accumulate financial assets, and our time remaining in the labor force decreases, the amount of human capital relative to financial assets shrinks. This shift over time should be considered in terms of the asset allocation decision.
The second point is that we need to not only consider the magnitude of our human capital but also its volatility. Some people (such as tenured professors, doctors and government employees) have stable jobs, and thus their labor income is almost like an inflation-indexed annuity. In other words, it acts very much like a bond. Other people (such as commissioned salespeople and construction workers) have labor income that is more volatile, and thus acts more like equities. Financial advice should incorporate these differences.
For example, for people with safer labor income, it might be appropriate to invest more aggressively—with a higher allocation to equities overall and perhaps higher allocations to riskier small and value stocks. Those with riskier labor income should consider holding less aggressive portfolios (those with higher bond allocations).
This gets to the heart of Markowitz’s work on portfolio theory: An asset shouldn’t be considered in isolation. Note there may be times when the riskiness of one’s human capital changes (after a career change, for example). If the riskiness of the human capital increases, one should consider reducing the riskiness of the other assets in the portfolio, and vice versa.
A related issue is the significance of human capital as a percentage of total assets. If human capital is a small percentage of the total portfolio (because there are large financial assets), the volatility of the human capital and its correlation to financial assets becomes less of an issue.
Correlation, Health And Mortality
The third point we need to consider involves one of the most basic principles of investing—don’t put too many eggs in one basket. Individuals should avoid investing in assets that have a high correlation with their human capital. Unfortunately, far too many people follow Peter Lynch’s advice to “buy what you know.” The result is that they invest heavily in the stocks of their employers.
This is a mistake on two fronts. The first is that it’s a highly undiversified investment. The second is that the investment is likely to have a high correlation with the person’s human capital. Employees of such companies as Enron and WorldCom found out how costly a mistake that can be.
The fourth point to consider is that human capital can be lost due to two risks that need to be addressed by means other than through investments. The first is the risk of disability. This risk can be addressed by the purchase of disability insurance. Thus, the risk of disability and how to address it should be part of the overall financial plan. The other risk is that of mortality. That issue can be addressed by the purchase of life insurance (we will discuss that in more detail).
There are still other points to consider. All else being equal, people with a high earning capability have a greater ability to take more financial risk because they can more easily recover from losses. However, they also have a lower need to take risk. All else being equal, the higher their earnings, the lower the rate of return they need from their investment portfolio to achieve their financial goals—they can choose less risky investments and still achieve them.
Risk Tolerance And Adaptability
Another factor is investors’ willingness to take risk—their risk tolerance. It’s important that investors don’t take more financial risk than their stomachs can handle. The reason is that, when the inevitable bear markets arrive, they might be more inclined to panic-sell, and the best laid plans would end up in the trash heap of emotions.
Even if they were not driven to panic, life is just too short not to enjoy it. One should be able to “sleep well” with his or her investments. Thus, a high earnings capability, or even a high need to take risk, shouldn’t necessarily result in an aggressive investment portfolio.
Yet another factor to consider is the ability to adjust your “supply” of human capital. Consider the following: You develop a financial plan that allows you to retire at age 65. However, the market’s rate of return falls below the expected return you built into your plan, or you weren’t able to save as much as you had expected. Now you will need to work longer.
Can you continue in the labor force? What level of income can you generate? Will the market allow you to sell your skills, and at what price? Younger workers typically have more ability to adjust their supply of human capital. In addition, those with a variety of skill sets also have a greater ability to adjust their supply to economic conditions.
We’ll revisit this discussion later in the week to consider additional risk factors, including mortality and longevity risk, and using “tax alpha” strategies to improve the odds of achieving your financial goals.
This commentary originally appeared April 12 on ETF.com
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