Risk Characteristics of Human Capital

Asset allocation should consider total wealth. Remember that total wealth is comprised of both financial capital and human capital

Total Wealth = Financial Capital + Human Capital

Human capital tends to be static unless the investor were to head back to school or otherwise augment their professional skills. This means that adjustments tend to be made to the financial capital component in order to achieve the optimal asset allocation to total wealth.

The Nature of Human Capital

Not all human capital is created equally. Some human capital is riskier than others, and some have more bond-like characteristics, while others have more equity-like characteristics. For example:

• Riskier human capital should lead to an overall more conservative asset allocation.
• Human capital that is highly correlated with the equity markets should lead to a more conservative asset allocation, diversified into other assets rather than equities.
• Individuals should always try to avoid too much financial capital directly related to their employer, as this increases overall risk in total wealth, not just human or financial capital alone.
• When a couple combines their human capital, they tend to be less than perfectly correlated. This means a couple earning $100,000 per year has less risky human capital than one individual who earns $100,000 per year alone.
• If one-half of a couple has a less geographically mobile set of professional skills, their income stream may be riskier in the case the other half of the couple needs to move.
• One member of a couple who isn’t working but could return to work if they wanted to decrease the riskiness of human capital.
• Human capital is generally less risky than financial capital and should not lead to large shifts in asset allocation of financial capital.

Question

Arun and Alicia Rodgers are a young couple with three young children. Arun works a steady job as an engineer at Derna Corporation (Ticker: DRC). Alicia stays home with the children and has been a homemaker her whole life. The couple is renting a home and has just recently begun saving for the future. As part of Arun’s bonus package, he gets a bonus when DRC stock finishes the year above its previous price. Arun also gets a 5% market discount when he purchases DRC stock in his tax-deferred savings account, which he has recently taken advantage of. Arun has not yet purchased any insurance as he is not a homeowner and does not like the idea of life insurance as he considers himself healthy.

Based on the case facts, which adjustment should be made to the couple's financial capital?

1. +5% to equity allocation.
2. No adjustment.
3. -5% to equity allocation.

Solution

The correct answer is C.

This is a typical exam day case that a candidate may need to analyze. Make sure to look at each point and consider in what direction it points, taking into account the overall effect of the totality of the facts stated in the case.

The only fact in this case that supports a higher allocation to equity (answer choice A) is the fact that Arun works a steady job. Every other fact in the case points to a need to be more conservative in asset allocation, including:

Facts related to human capital:

• Arun's income is tied to his company's stock.
• Arun's savings is tied to his company's stock.
• Alicia does not work and does not seem to have marketable professional skills.

Facts related to the couple's financial capital/situation:

• The couple has three young children.
• The couple has no insurance.
• The couple has no home.
• The couple has little savings.

This question did not ask specifically to analyze the case facts related to human capital or financial capital, but this may well be a distinction that would need to be made on exam day and could lead to missed points if the distinctions weren't properly made.

Reading 9: Risk Management for Individuals

Los 9 (j) Discuss how asset allocation policy may be influenced by the risk characteristics of human capital