One of the most important of these circumstances is our job. Your ability to earn a living - your human capital - is part of your portfolio of assets: it might well be the biggest component of it. And when you judge risk it is your whole portfolio that matters. The type of job you do should therefore influence how many and what type of equities you own.
If you're in a safe job you can afford to take more equity risk than if you're in a risky one, because your job, in effect, gives you a bond, a relative safe asset. And if you're at risk of losing your job in an economic downturn you should own fewer cyclical stocks than average because these are likely to do especially badly when you most need financial wealth, to tide you over a loss of earnings. Other things being equal, therefore, doctors should own more equities than architects and architects should own fewer construction stocks than other investors as these would do badly in the sort of circumstances when architects are suffering falling earnings.
However, this is often not what we see. Very often, people are overweight, not underweight, in shares in the industries they work in. The kindest thing one can say about this habit is that it is a way of reducing ambiguity aversion, our distaste for the unfamiliar. A less kind possibility is that it is yet another sign of overconfidence; people over-rate the extent to which working in an industry gives them an idea about stocks' future returns.
Human capital, though, isn't our only idiosyncratic feature. We often have other background assets. For example, if you are long of housing - either because of a buy-to-let portfolio or because you hope to trade down - then for you housing stocks are especially risky since they would do badly around the time that you suffer from falling house prices. (I stress around the time because house prices are slower to respond to bad news than share prices.) You should therefore own fewer housing stocks than the average investor. And you might want to own foreign currency, because sterling tends to fall when house prices do so profits on foreign currency would offset losses on housing.
There are many other examples of background assets. If you own (say) a road haulage company you are vulnerable to rising oil prices. You might therefore want to own more oil stocks or (better still) an oil exchange traded fund than the average investor, to mitigate your unusual risk exposure.
Or if you have lots of flat-rate annuities you are unusually vulnerable to rising inflation so you might want to hold lots of hedges against inflation such as index-linked bonds, commodities or foreign currency.
Yet another idiosyncratic circumstance is how close we are to our target level of wealth. If you are close to it (say because you can just about afford to retire) you will be loss averse. This is because a loss of (say) £100,000 would give you much more pain than a gain of £100,000 would give you pleasure. In such a position, it makes sense to reduce risk.
Economists believe that the standard advice that old people should own fewer equities than young ones is mostly nonsense. But it might make sense once we factor in target levels of wealth. To the extent that oldsters are nearer their targets than youngsters, they should own fewer shares.
So far, I 've considered how idiosyncratic circumstances can increase your exposure to particular risks. But this is only half the story. Our personal circumstances can be such as to allow us to take on risks and so earn risk premia that others are avoiding. Take three examples.
• Retail investors are not like professional fund managers. They worry that if they underperform their benchmarks they will get the sack. We don't have this problem. We can therefore afford to take the benchmark risks that they avoid. This means we should own defensive stocks, as these outperform on average partly as a reward for the risk of underperforming in a great bull market.
• If you are retired you are no longer exposed to recession risk; you've no job or business to lose. This means you are better able to take on cyclical risk. Retired investors should own more construction and mining stocks than non-retired ones, other things equal.
• If you are a genuine long-term investor who can afford to tie up money for years you can buy assets that are vulnerable to liquidity risk - the inability to sell them at good prices in hard times. You can therefore own more commercial property or private equity than others. (I must caveat this, though. Some people think they are long-term investors in good times, only to discover in bad times that they are not. For them, illiquid assets are disastrous.)
In ways such as these, idiosyncrasies matter. Our personal circumstances should shape our portfolio choices.
You'll have a question here: isn't this inconsistent with my advice to own tracker funds?
Not entirely. Somebody must be the average investor. And the average investor must own the market portfolio, by definition. And most of us are average to some extent and so tracker funds should be part of our portfolio.
Investment is not like interior design; it isn't entirely a matter of personal taste.
But it is to some extent. I fear that investors pay too much attention to their idiosyncratic beliefs - the notion that they have a better idea than others which stocks will beat the market - and not enough to their idiosyncratic circumstances. And yet these should shape our investments.
