When it comes to drawing up an investment plan, most investors will tally up their existing assets, draw up a list of their goals and desired retirement lifestyle, identify their tolerance for taking risk with their finances, and then embark on researching different asset classes and investment vehicles for achieving these goals within the self-set boundaries of risk.
But when it comes to identifying one's tolerance for risk, many risk questionnaires do the simple job of asking people their preferences rather than accounting for how much risk they can afford to be comfortable with. A more holistic approach to identifying risk appetite is to not only look at financial capital but also at what Thomas Idzorek, CIO of Morningstar's investment management division, terms 'human capital'.
The idea of all one's human capital requires that the investor takes into account their earnings potential as well as the volatility of their earnings. A 20-year-old investor has a lifetime of earnings ahead of them, and depending on their career choice the potential for what they might earn over the next half century will vary quite dramatically. But in addition to this, irrelevant of age and investment time horizon, one person's earnings will be more or less volatile than the next person's.
Take, for example, a tenured university professor. Once tenured it's very difficult to be laid off, so this professor has a great deal of certainty about what his or her income will be year in and year out. He or she can therefore afford to be more aggressive when allocating their financial capital. Perhaps at the other end of spectrum, let's take an investment banker. As a financial professional he or she may think they can take on more risk than the average investor, based on the assumption that they're better educated on the world of investing or that their salary at any one time is notably higher than the national average. However, the average income of a typical investment banker saw a dramatic drop year-on-year in 2008, he/she potentially had to dip into savings during the financial crisis in order to pay their living costs and his/her earnings potential is likely tied closely to the financial markets. It could be argued that this second professional has a lesser capacity to take on risk within their portfolio.
Thus it's important to decipher whether your lifetime capital is more bond-like or more equity-like in characteristic, and to adjust your investment plan accordingly.
It's also important to note that human capital has a built in inflation hedge, given that salaries tend to rise with inflation. So a younger investor doesn't need to be invested in inflation-linked bonds, for example, while a retiree who no longer has that in-built inflation hedge should, all other things being equal, be invested more heavily in those asset classes that hedge against inflation.
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