One of the big rules of investing is that what matters is our portfolio as a whole. We can cope with losses on one or two assets if they are offset by profits elsewhere, but perhaps not if they are accompanied by other losses. For many of us, however, one of our biggest assets – and for younger investors by far their biggest asset – is our human capital, our ability to earn a living. We should regard this as part of our portfolio of assets. And doing so overturns some conventional financial advice.
The first question to ask is: is my human capital like a bond or an equity? If your earnings are volatile and insecure it is an equity, but if they are stable it is a bond. And if you hold lots of bonds you can afford to take on more equity risk. Other things equal, therefore, doctors should hold more equities than architects.
Although this might seem obvious, it implies that one longstanding piece of financial advice is wrong – that young people should own more equities than older ones. This is because, generally speaking, younger people’s human capital is more volatile than older people. They are more uncertain about their future careers: they cannot truthfully answer that cliched question, 'where do you see yourself in five years’ time?' Such uncertainty is partly cyclical; in a boom it is youngsters’ whose career options improve the most and in a downturn it is theirs who suffer the most while those in settled careers are less vulnerable. Young people’s human capital is therefore more like an equity than older ones’. On this account they should own fewer equities than older folk. And they should increase their equity exposure as they age and as their human capital becomes more like a bond. This is the exact opposite of the idea that we should own fewer equities as we age.
Of course, not everybody’s human capital does become more bond-like. Some stay in cyclical jobs. For these, equities actually become safer when they retire because there is no longer a risk of them losing money on their financial assets at the same time that they lose their jobs or bonuses. These should therefore own more equities when they retire – again, against the conventional advice that we should switch to safe assets as we age.
A second way in which human capital challenges conventional advice concerns international equity diversification.
What matters here is: what type of risk does our human capital face?
One possibility is that we suffer what Japan did in the 1990s – a country-specific 'lost decade' of economic decline in which shares fall and job prospects deteriorate. In this case, international equity investing works well; the Japanese investor who had bought US stocks in 1990 would have done very well in the following 10 years. Investing your human capital and your equities in the same country means putting all your eggs in one basket. That’s obviously silly.
But this is not the only danger. Remember the early 1980s. Many workers then suffered unemployment, and millions more faced huge uncertainty about their human capital. But soaring share prices offset these losses. This tells us that when there is distribution risk – the danger of a shift from wages to profits – domestic equities diversify human capital nicely. International diversification, however, might not do so. In the 1970s, for example, wages grew at the expense of profits and share prices slumped. But this happened in many developed economies and so spreading equity investments around the world did little good.
I suspect both these risks are real today. A hard or no-deal Brexit risks a Japan-style lost decade of weak growth. But a Jeremy Corbyn government might try to transfer wealth and incomes from capital to labour.
Such aggregate risks, however, are not the only threats to our human capital. Another is simply that our job just doesn’t work out for reasons specific to ourselves or our boss. This danger is independent of macroeconomic conditions: it could just as well happen when the economy is doing well as when it’s doing badly. Equities diversify this risk but do not insure against it. For this, you need safe assets such as cash.
A further danger is that you could suffer an industry-wide downturn. This means you should not own shares in the industry you work in. Yes, you probably know more about the companies in your own industry, but this advantage is offset by the fact that you are putting all your eggs into the same basket. You should invest in sectors uncorrelated with, or negatively correlated with, the one you work in. In many cases, however, there are few of these.
Of course, we each have different types of human capital. And this means that rational people will – to some extent – own different financial portfolios. One size fits all general financial advice can therefore be incomplete.
