22
For Advisor Use Only
March/April
2014
Wealth Management
/ Investments & Research
portfolio in equities, while those with more volatile income
patterns, such as at-will employees, should use a more
conservative allocation. Individuals whose labor income
is highly correlated to equity markets should consider
reducing their exposure to risk assets in their financial
portfolio, and those with a higher flexibility around labor
income should increase their equity allocation.
Let’s look again at the 25-year-old investor we previously
mentioned. He has a stable income stream that is
noncorrelated to equities, so the financial portfolio for
this individual would generally be allocated entirely to
stocks. In this case, the total wealth portfolio would be
approximately 4-percent equities and 96-percent bonds
(human capital). On the other hand, if the 25-year-old
had a highly volatile income stream correlated to equities,
then the financial portfolio should have a preference for
bond-like securities because the human capital portion
of total wealth would exhibit equity-like characteristics.
Advisors who use the human capital component in
formulating asset allocation decisions should consider
these main themes:
•
Financial capital portfolios should be diversified in such
a way as to balance out the human capital portfolio.
•
An investor whose human capital is highly correlated
to risk markets should reduce the allocation to equities
in the financial portfolio and increase exposures to
bond-like instruments.
•
Labor income flexibility and stability in cash flows
should result in increased exposures to equities; however,
the allocation to equities should decrease as an individual
approaches retirement.
•
Unlike bonds, human capital is illiquid, so investors
may still wish to keep a portion of their investable
assets in more conservative investments as a safety net.
Naïve Diversification
Finally, one of the most common asset allocations we see
for young investors is something called
naïve diversification
.
Rather than using principles founded in modern portfolio
theory, young investors unwittingly often use a 1/N approach
to portfolio diversification.
For instance, if a 401(k) platform has four strategies, a
novice investor will generally allocate 25 percent (1/N or
1/4) to each holding, which often results in very risky
portfolios or unintended overweights. If the platform
offers a large-cap, small-cap, emerging market, and bond
fund, for example, the investor will effectively wind up
with a 50-percent allocation of the portfolio to small-cap
and emerging markets. This outcome would result in an
extremely aggressive allocation and probably wouldn’t be
suitable for most investors.
Cultivating a Younger Client Base Can Mean
a Healthier Practice
Because much of their potential net worth is tied up in
human, rather than financial, capital, young investors
often do not receive the same level of attention from
financial advisors as their more senior counterparts. But
advisors looking to support the long-term health of their
businesses would do well to help inexperienced clients
overcome their unique challenges.
The assets of young clients grow more quickly, and the
business they can give to advisors has more longevity. In
addition, young investors can be a key to winning new
referrals or retaining the business of older relatives. By
addressing the issues of these new investors early, advisors
have the opportunity to build solid, long-term relationships
whose returns will compound over time.
Peter Essele is a senior investment research analyst. He is
available at x9627 or at
.
Sean Fullerton is an investment research analyst. He is
available at x9262 or at
.
