Wealth Management
/ Investments & Research
20
For Advisor Use Only
March/April
2014
when it comes time for an advisor to sell his or her book
of business because the longevity and growth potential of
younger clients’ assets tend to be higher.
First Think Holistically, Then Bucket Savings
Many novice investors engage in “mental accounting,”
artificially designating certain assets for specific purposes
while not assessing their financial situation from an
overall perspective.
Two major areas where mental accounting disproportionately
affects young investors are student loan debt and credit
card debt. Commonly, in a commendable effort to save
for retirement, young people contribute a significant portion
of income to their 401(k), IRA, or traditional brokerage
accounts and delay paying down high interest rate credit card
and student loan debt, even though these rates often reside
in the high teens. Paying off student loans should be viewed
as a top priority, however. There are two reasons for this.
A risk-free investment.
First, student loan interest can
be viewed essentially as a risk-free investment, similar to
a U.S. Treasury bond. Assuming the 30-year Treasury
yields less than 4 percent, young investors are essentially
saving themselves double the interest rate of a Treasury
by paying off an 8-percent interest loan. Compared with
stocks, which could return more than 8 percent over a
30-year period, paying down student loans still often makes
sense because the return stream of investing in the loan
has zero volatility.
Interest is front-loaded.
Second, most student loans behave
according to an amortization schedule, which means that
interest is front-loaded. By paying down principal early,
young investors can save thousands or even tens of
thousands of dollars in interest over the life of the loan.
To view the benefits of paying down interest early on
amortized debt, we need look no further than Microsoft
Excel. If we simply right-click on a tab, click Insert, select the
Spreadsheet Solutions tab, and open the Loan Amortization
template, we can enter various assumptions and easily
calculate interest expenses for an entire loan period.
There are, of course, exceptions to this rule of thumb. If a
company offers its employees a 401(k) matching program,
for example, a young investor might be wise to take the
opportunity to contribute up to the highest level matched
by the company, instead of pouring that money into paying
down other debt.
Once a young investor and his or her advisor have reviewed
the investor’s financial situation from a holistic perspective,
they can then consider bucketing assets (i.e., designating
assets for specific purposes). For example, a young investor
might keep most of her taxable assets in high-quality,
low-duration bonds, anticipating the purchase of a home
over the next year or two. At the same time, she and her
advisor might invest qualified assets very aggressively,
having earmarked them for retirement.
Human and Financial Capital
Individual investor characteristics vary widely. This point
is often overlooked in the asset allocation stage, especially
by financial advisors who use a model-based approach
across client accounts. Also often overlooked in the
construction of strategic allocation is
human capital
.
Arguably among the most important
components of portfolio design, especially
for younger generations, it is a somewhat
new concept.
Human capital is the present value of all
expected future labor income. In addition to
human capital, an individual has
financial
capital
, which includes investable assets, such as stocks,
bonds, real estate, and any other investable asset. For
young investors, human capital is generally the largest
piece of the pie because younger people have a long horizon
of earnings ahead and very little financial capital to invest.
For the purpose of asset allocation, human capital
should be considered as one would consider a fixed
income position.
