When we determine the appropriate asset allocation for an individual investor, the amount of risk the person can be exposed to not only depends on the amount of risk they can tolerate, but also on the total financial situation of the investor. Earnings exclusive of the investment portfolio are a critical component of determining the capacity for risky assets. Investors with high earnings potential are able to stomach more risk because they can easily recoup negative movements in the financial market.
We have all been told younger investors should take a more aggressive stance with their investment portfolio. This advice is a direct application of the human capital concept. Human capital is the present value of one’s future earnings potential. Although human capital is illiquid and not readily tradable, it is often the largest asset an investor has. Typically, younger investors at the beginning of their careers have more human capital than financial capital and have many years to work and increase their financial capital. Conversely, older clients typically have accumulated far more financial capital and have far less human capital left as they approach retirement. As the investor’s human capital diminishes, the allocation to less risky assets would increase. When developing a client’s asset allocation, human capital should be treated like any other asset class as it has its own risk and return properties. But is this always the case?
When working with high and ultra-high net worth investors, the typical human capital allocation must be adjusted. More often than not, high and ultra-high net worth investors have income outside of their investment portfolio that covers their expenditures. Should their investment portfolio allocation be consistent with the human capital framework? We would argue no, on the principal that each client experience is unique and should be managed to their own long term investment plan. This subset of investors have the ability to hold more risky long-term assets and do not necessarily need to increase their position in fixed income as they age. We look past managing assets to particular benchmarks and instead make sure we are managing the assets to our client’s individual plan and the goals associated with that plan. We cover our investment process in greater detail in our white paper. The allocation framework including human capital cannot be viewed as black and white with a standard blueprint to follow for each client. Each client experience is unique and we seek to make sure our investment portfolios are positioned to meet their individual goals.