Asset Allocation Relative to an Investor’s Economic Balance Sheet

An economic balance sheet differs from a traditional balance sheet as it includes tradable financial assets and non-tradable extended assets and liabilities. Extended assets often include the relatively large values of residential real estate and the present value of human capital. Including these assets in the investor’s portfolio will increase the ability to take risks. This means many asset allocations based solely on financial assets may be too conservative.

Modeling Extended Assets – Human Capital

Modeling the present value of human capital begins with determining the makeup of the investor’s earnings. Suppose the cash flows come from steady employment in relatively stable industries. In that case, the analyst will likely determine that the present value of this cash flow stream will most closely resemble fixed income. Think government jobs, teachers, engineers, etc.

On the other hand, seasonal, sales-oriented employment, which works on commissions, bonuses, or prizes, may be treated more like equity rather than fixed income. Think hedge fund managers or race car drivers.

After determining the properties of the investor’s human capital, the analyst must use the present value to determine the fixed weight in the portfolio. This is necessary as human capital is a non-tradeable asset.

Modeling Extended Assets – Residential Real Estate

Residential real estate often represents a significant portion of an investor’s wealth. The most straightforward way to include real estate in an investor’s economic balance sheet—and thus determine asset allocation—would be to use a residential real estate index.

Question

Including extended assets in asset allocation is most likely to increase:

1. Time horizon.
2. Ability to take risks.
3. Liquidity.

Solution

The correct answer is B:

By including extended assets (expected inheritances, present value of future earnings, residential real estate, etc.), an investor will experience an increased capacity to take on risk. This comes about due to a more significant amount of total wealth owned by the investor than the previous consideration of only considering financial assets. These extended assets will often show an increased exposure to fixed income and real estate, leaving more room for riskier equities in the portfolio.

A is incorrect. Time horizon concerns the investor’s aspirations for retirement and cash flow needs, not necessarily the makeup of the investor’s assets.

C is incorrect. Liquidity is not likely to be increased as neither houses nor future earnings are liquid.

Reading 5: Principles of Asset Allocation

Los 5 (c) Interpret and critique an asset allocation in relation to an investor’s economic balance sheet