Answering that question is one of the keys to successful asset allocation and financial planning according to a growing number of academics and financial executives.
You are a bond if you have a stable job unaffected by the gyrations of stock markets, and many years left to work. (You’re also pretty fortunate given the current job market!) On the other hand, if you work in a volatile and unpredictable field that could drop quickly with little notice, you’re more of a stock.
This stock/bond question is one way of looking at the idea of human capital and the question of how we can integrate our work outlook into our investing and financial plan. Human capital in this context is the current value of our long term earnings. That combined with our financial capital, or savings, equals our total wealth. And too few people take their human capital into account when allocating their financial investments, experts say.
One element of human capital is simply our stage in life. The young have many years of work ahead and, therefore, lots of human capital, though generally not much by way of financial capital (or savings). Someone close to or in retirement is at the opposite end of the spectrum. They’ve used up their human capital and hopefully have lots of financial capital to ride out the rest of their days.
Source: Ibbotson Associates
A person’s risk tolerance and age should not be the only things considered when assessing our human capital however — the characteristics of our job must play a factor too.
Who is a bond?
1) The young.
Someone in their 20s might feel like a growth stock — full of potential, capable of incredible bursts of remarkable performance, moody — but actually they’re more like fixed income. According to Ibbotson Associates, which has patented a way of using human capital in designing asset allocations, the younger you are the more bond-like. Human capital itself is in some ways like a bond, according to the firm’s experts, lead by Yale School of Management Professor Roger G. Ibbotson, and younger people have more of it. Like “regular interest payments from a bond, workers earn a weekly salary from which they accumulate savings. Younger investors have far more of this bond-like human capital than older investors because they have a long time horizon to earn and save. So to balance out that large allocation to human capital, for example, younger investors should hold their financial capital in more aggressive investments.”
Of course younger investors can also better handle the volatility of aggressive investments, since they have time to make up for losses, but this is a different rationale for ending up at the same place, and one that should be less influenced by ideas like personal risk tolerance. No matter how weak-kneed you feel, if you are in your 20s be aggressive with your investments because the other part of your wealth (human capital) is as bond-like as it will ever be.
2) People in stable jobs.
What you do also impacts how bond-like you are. “Policemen, firemen, tenured professors, those jobs are very bond like,” says Moshe A. Milevsky, a finance professor at York University’s Schulich School of Business in Toronto, because those jobs are relatively stable and are not likely to be quickly cut at times of stock market and economic turmoil. But “working on Wall Street is very stock-like.” Milevsky, who has written a book on human capital called Are You a Stock or a Bond?, is himself tenured and though he’s into his 40s says he has 100% of his investments in stocks. Not because he’s a reckless risk taker, but because he himself is such a bond.
How much of a bond are you?
If a Supreme Court Justice is 100% bond, and a derivatives trader is 100% stock, what about all of the people who fall somewhere in between? In a piece in the Wall Street Journal, Milevsky urges us to delve into figuring out our “personal beta” or how sensitive our jobs are to changes in the stock market, as a measurement of how much risk is already baked into our financial outlook just based on where we check in each weekday morning:
If a stock has a beta of 1, it means that it’s likely to move pretty much in tandem with the overall market. A beta above that means that if the market falls, the stock will likely fall by even more; a beta below 1 means the stock won’t move as much as the market.
Similarly, if you have a personal beta of 2, it means that if the market goes down 25%, your paycheck plummets 50%. If you think that a 25% drop will have absolutely no impact at all on your livelihood—although I doubt it—then your personal beta is zero. If you want to get a back-of-the-envelope measure of your personal beta, ask yourself how the past few years have affected your paycheck.
“Ignore your beta at your own peril,” he writes.
Another way to look at this question is if you are a bond, what kind are you? Are you a junk bond with a high dividend, but a significant default risk or a Treasury that’s paying out little, but is relatively rock solid? Michael Gordon, a senior vice president at New York Life, has built a fast-growing $200 million business around integrating insurance decisions that protect your human capital, like buying life insurance, into your overall financial planning. He takes a broader view beyond the market into the general volatility in ones work. “The question (if I’m a bond) is how volatile is the income stream or cash flow that is going to come off of me as an investment and how do they correlate to the other investments in my portfolio? If it’s riskier than average, you may want to make the rest of your portfolio a little less risky as a counterweight.”
The role of insurance.
Ibbotson and Milevsky both argue that human capital is vulnerable to many factors beyond the stock market. For starters death, disability and an extended illness. A small business owner should even consider disability income insurance, Milevsky says.
In human capital terms you need life insurance the most when you’re the least likely to die, in other words when you are young. A bit counter-intuitive since we often don’t worry about life insurance when we’re young since 1) we don’t really think we’re going to die, and 2) we may not yet be earning much and, therefore, see little need to insure against that loss of income. From a Human Capital perspective that’s completely wrong. The young have lots of as yet unearned income and maybe millions of dollars worth of human capital that insurance can protect. As we get older and towards retirement, we may be closer to dying, but we are also closer to no longer needing that insurance.
If you do buy that insurance needs to play a role, New York Life’s Gordon warns you not make that decision in isolation. A 35 year old who wants to be 20% invested in bonds and 80% in stocks, needs to understand that buying a whole life policy with an income component, for example, is equivalent to upping his fixed income stake, leaving him more like 25% in bonds, 75% in stocks. And anyone buying insurance obviously needs to do some research on the financial strength and track record of the insurance company.
Like any good insurance salesman, Gordon worries that people don’t have a full enough understanding of their risks from the value of their human capital right down to their life expectancy. (Life expectancy means there’s a 50% chance you’ll live longer than that figure.) “People face market risk, inflation risk, mortgage or negative mortgage risk, health risk, a number of different risks,” he says. “Most of the (planning) tools do a great job on market risk, but when look at other things they’re typically not incorporated.”
Given the increased volatility of the markets, and the fact that asset performance has been so closely correlated in recent years, Milevsky says people must take a more holistic view of their assets when planning. “If financial diversification breaks down in times of crisis, then we have to look more widely for diversification. If the financial diversification was enough I wouldn’t have to worry about human capital.”
Photo: James Lee