Harry Markowitz received the Nobel Prize in economics 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 that 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 how important is the role 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 where 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 then 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.

When developing an overall financial plan there are other risks that are important to consider. Not integrating the management of these risks into an overall financial plan can cause the best investment plans to fail. 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. (Note that many of the issues covered here are discussed in Roger Ibbotson, Moshe A. Milevsky, Peng Chen and Kevin X. Zhu's “Lifetime Financial Advice,” The CFA Institute (2007)).

Human Capital Risk

We can define human capital as the present value of future income derived from labor. It is an asset that does not appear on any balance sheet. It is also an asset that is not tradable like a stock or a bond. Thus, is 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 is also often the largest asset individuals have when they are young. As we age and accumulate financial assets and the time we have 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 (e.g., tenured professors, government employees) have very 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 (e.g., commissioned salesmen, 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—have a higher allocation to equities overall and perhaps also to riskier small and value stocks. Those with more risky labor income should consider holding less aggressive portfolios (ones with higher bond allocations). This gets to the heart of Markowitz’s work on portfolio theory—an asset should not be considered in isolation. Note that there may be times when the riskiness of one’s human capital changes (e.g., a career change). 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 (i.e., there are large financial assets), the volatility of the human capital and its correlation to financial assets becomes less of an issue.

The third point we need to consider involves one of the most basic principles of investing—do not 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 is 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 through 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 equal, the higher one’s earnings, the lower the rate of return one needs from their investment portfolio to achieve their financial goal. The result is that they can choose less risky investments and still achieve their goals.

Another factor is the investor’s willingness to take risk—their risk tolerance. It is important that investors do not take more financial risk than their stomach can handle. The reason is that when the inevitable bear markets arrive they will be more subject to panicked selling, and the best laid-out plans will end up in the trash heap of emotions. And 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 their investments. Thus, a high earnings capability, or even a high need to take risk, should not necessarily result in an aggressive investment portfolio.

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 don’t save as much as you had expected. Now you will need to work longer. The questions are will you have the ability to continue in the labor force and what level of income will you be able to generate? Will the market allow you to sell your skills, and at what price? Younger works typically will 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.

Mortality Risk

For those families where human capital makes up a substantial portion of their total assets, protecting that capital via the purchase of life insurance should be part of the overall financial plan. Life insurance is the perfect hedge for mortality risk as its return is 100 percent negatively correlated with the human capital asset. The younger the investor (the higher the human capital), the greater will be the need for life insurance. The amount of insurance required can be determined through what is called a needs analysis. It can also be related to bequeath motivations.

It is important to note that life insurance can be used for purposes other than to hedge mortality risk. For example, life insurance may be the most effective way to pay estate taxes. It can also be a useful tool in terms of business continuity risks. Thus, while the individual’s need for insurance to hedge the risks of human capital falls as he ages, the need for insurance might actually increase.

Longevity Risk

We can define longevity risk as the risk that you will outlive the ability of your portfolio to support your desired lifestyle. This risk has increased for much of the population with the decline of defined benefit plans (which, like social security, pay out for a lifetime) in favor of defined contribution plans. And advances in medical science continue to expand life expectancy. This risk can be addressed by the purchase of lifetime payout annuities.

While the academic literature demonstrates that many investors would benefit greatly from the purchase of payout annuities (because of what is known as mortality credits built into the product—in effect, the people who die earlier than expected subsidize those that live longer than expected) very few are purchased. The main reason seems to be that people are risk averse; risk averse in the sense that they don’t want to run the risk of giving up their assets and then dying in the near future. The fear is that the assets are no longer available for their heirs. But this is only true if they live a shorter than average life. By definition half will live longer. And for those living longer than expected, buying a payout annuity actually preserves any remaining assets for the estate.

The academic literature suggests that investors should begin to consider purchasing annuities at around the age of 65 and should buy them before they reach age 85. Since the payouts from annuities are dependent on the level of interest rates (among other things) a recommended strategy is to diversify the interest rate risk by purchasing various annuity contracts over time, instead of all at once. This strategy also preserves liquidity for some period of time. Monte Carlo simulations help analyze the benefits of annuitization.

There is another related risk. As we age the risk of needing some form of long-term health care increases. Thus, investors when developing an overall financial plan should consider the purchase of long-term health care insurance. Again, the use of Monte Carlo simulations can help analyze how the purchase of long-term health insurance impacts the odds of achieving one’s goals.

Summary

Human capital is a critical asset that should be considered as part of an individual’s portfolio of assets. And it is critical that investors integrate assets other than investment assets and risks other than investment risks into their financial plans. Doing so diversifies/hedges risks that financial assets cannot hedge; risks such as mortality and longevity.

The following is a brief summary of some of the key points we have covered:

1. In general, younger investors with more labor capital should invest more in stocks than older investors.
2. Individuals with safer human capital have a greater ability to invest more in risky assets. Those whose human capital more highly correlates with equity risks should allocate more to safer fixed income investments.
3. Individuals should diversify their human capital, minimizing investments in assets that correlate highly with their labor income.
4. Individuals should hedge their human capital risks through the use of insurance contracts (disability, life and long-term health care).
5. Individuals should consider hedging their longevity risk through the use of payout annuities.

_{Disclosure: Larry Swedroe is the author of Wise Investing Made Simple (2007), The Only Guide To A Winning Investment Strategy You Will Ever Need (2005), What Wall Street Doesn’t Want You to Know (2000), Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today (2002), and The Successful Investor Today: 14 Simple Truths You Must Know When You Invest (2003), and co-author of The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006). He is also a Principal and Director of both Research of Buckingham Asset Management and BAM Advisor Services — a Turnkey Asset Management Provider serving CPA-based Registered Investment Advisor (RIA) practices — in Clayton, Missouri (www.bamservices.com).}

_{His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.}