While portfolio management understandably focuses on how best to allocate a portfolio, the reality for many (or even most) investors is that their financial assets may not even be the majority of their total net worth, compared to other assets like real estate, the (illiquid) value of their pensions and Social Security, and for those who haven’t retired yet, their human capital. In fact, for younger workers, their human capital – or the present value of their future earnings from employment – may actually be the largest asset they own!
Yet the reality is that assets like human capital, illiquid pensions and Social Security, and even real estate (especially if in the form of a primary residence) are not easily traded or altered; in other words, whatever you’ve got, and the risk it entails, is largely what you’re stuck with. In turn, this suggests that if the individual is going to try to optimize the risk and return of their total net worth – across all these different “asset classes” – that the portfolio is the one that should change to accommodate the rest, because it is the most malleable.
And in fact, recent research from Morningstar suggests that, when viewed on this basis, the optimal portfolio allocations for many investors really do shift, potentially quite significantly! Human capital, in particular, plays a significant role, given that both the growth rate potential and the volatility risk can vary quite a bit from one industry to the next, and different industries themselves have varying correlations to different segments of the market and (financial) asset classes. Which means, in the end, that advisors who are not considering these other balance sheet risks – especially for the human capital of their working clients – may be significantly over- or under-risking the client’s total household balance sheet over time!