Unlocking Real Value Blog

How to Think Smarter About Risk

There was an interesing article in the WSJ recently entitled How to Think Smarter About Risk. Many of the ideas are worth thinking about and incorporating into your business if you are an advisor, although I have to admit that there were a few things in the article that I disagreed with.

The primary point of the article is that while many advisors consider how clients feel about risk and how they feel about the market overall (bullish v. bearish sentiment) when devising an asset allocation strategy, they often neglect to take into account the client’s human capital – their personal balance sheet.

Human capital is essentially a measure of future earnings. For example, if you work in the financial services industry, even if you are very optimistic about the market and willing to take a lot of risk, since your job might be at risk in another market downturn, this risk factor should be incorporated into your asset allocation (in essence resulting in a more conservative approach). The article contrasts this to a professor with tenure, where their job is relatively safe. Human capital can be quantified in terms of beta – is your beta higher or lower than the market? Thought of another way, are you more like a bond (risk-averse) or a stock?

I agree that human capital should be considered when an investor and their advisor devise an asset allocation. Part of the value-added of hiring an advisor is that he/she is able to incorporate the many facets of your life into your investment plan. A good advisor will take the time to really get to know clients and not simply base the investment plan on the answers to a 10-question risk assessment. I also agree with the article that decisions to buy insurance should also take human capital into account. The more stable the value of your human capital, the more insurance you should have to protect it, and vice versa.

One point that I don’t agree in the article, however, is its contention that high beta investors – investors whose human capital tends to fluctuate with the market and who should therefore be somewhat more conservative in their investments – should have little invested in the market during the first decade or two of their working lives, and more than conventional wisdom recommends during the later years. This idea, in my opinion, fails to take into account the powerful value of compounding. Factor your human capital in – yes – let it dictate your investing – no.

I also disagree with the authors take on education. The premise that the decision of what degree should be pursued should be intertwined with a eye toward hedging your long-term human capital seems somewhat cynical. If my son wants to pursue an undergraduate degree in history on his way to law school or whatever else he does, I for one am not going to try and dissuade him.

My conclusion is that while the article takes the issue of human capital a little too far for my tastes, the concept itself is important and advisors that integrate this issue into their fact finding and asset allocation decision-making are not only doing their clients a great service, but perhaps distancing themselves from the competition at the same time.

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