Most of what you read in magazines about financial planning is wrong. Those formulas where you subtract your age from 100 to get your suggested stock allocation? The asset pie charts that will supposedly shepherd you safely through your golden years? They ignore the most important element shaping your finances—something that should be factored into every aspect of your investment strategy: your career, or what financial types loosely call human capital. After all, for most people their job is their largest financial asset, and a salary provides the bulk of their wealth.
The moment human capital is included, however, complex questions arise. How, for instance, should the investment strategy of a tenured professor differ from that of an auto worker in a factory that may soon be closed? Should an executive at an oil company invest in energy stocks after they've had such a strong run?
What about brokers who used to work at Bear Stearns (BSC) before its meltdown? Should they have owned financial-services stocks or even owned stocks at all when their livelihoods depended so much on the stock market's moves?
The problem is how to turn your career into something quantifiable that can fit into a plan. One suggestion from financial researcher Ibbotson Associates is to think of your job as a type of financial security. "Years ago we had a meeting at Ibbotson with all these legends of finance and Nobel prize winners, such as Harry Markowitz and Daniel Kahneman, in which we debated what kind of security the average person's human capital is like," says Thomas Idzorek, Ibbotson's director of research. "We concluded it was like a junk bond. When times are good, it pays a stable income stream and trades like a bond. Then there's a hiccup, and it becomes volatile and trades like a stock."
To be more precise, Ibbotson judges the average person's human capital to be 70% like a bond and 30% like a stock. "The human capital of a tenured university professor with a stable income may be more like a portfolio that is 80% bonds and 20% stocks," Idzorek says. "Someone working in financial services, whose salary and bonus depend largely on the stock market, might be 50% bonds and 50% stocks." All other things being equal, the tenured professor should be investing more aggressively than the stockbroker.
Financial planners offer various solutions to the human capital conundrum. Adviser Matthew McGrath, a principal at Evensky & Katz Wealth Management in Coral Gables, Fla., factors it into the cash reserves he recommends clients keep to cover expenses should they lose their jobs. "If both spouses are at stable jobs in stable industries, maybe you need only emergency reserves to cover three months' worth of expected expenses," he says. "But if only one spouse is working you probably need six months' worth."
Some of McGrath's clients are self-employed business owners in cyclical industries such as retailing and real estate. Their incomes can vary greatly every year and even month to month. "These people often have a lot of illiquid assets that can't cover all their daily expenses," he says. "We get an estimate of their expected expenses for the next two years and put that in cash, money market accounts, and ultrashort-term bonds." Generally speaking, he puts the first year's worth of expenses in cash and the second year in slightly higher-yielding bonds.
McGrath says having such a cash cushion enables him to invest the rest of a client's assets more aggressively in traditional stocks and bonds. "The cash reserve separates clients psychologically from the market," he says. "They don't have to worry about what the markets are doing every day because they know their expenses are covered."
Some planners tailor the remainder of a client's portfolio to the industry she's working in, reducing or cutting exposure to certain sectors. "We replicate a global index of thousands of stocks but tailor it for the individual," says Joel Hornstein, CEO of Structural Wealth Management, a San Francisco planning firm with high-net-worth clients. "You have unique economic risks depending on your industry." Hornstein's strategy flies in the face of what traditional efficient-market theorists recommend—indexing to expose one's portfolio to every economic sector.
Before hiring Hornstein three months ago, venture capitalist Gina Raimondo worked with advisers at big brokerage firms, but she was frustrated with the results. "They offered me the three basic asset allocation plans—conservative, moderate, and aggressive—without even considering my venture capital exposure," she says. "It was very cookie cutter."
Raimondo's VC firm, which she doesn't want named, invests heavily in telecom, technology, and biotech startups. Her livelihood, and a significant portion of her net worth, is tied up in those industries. So Hornstein reduced her exposure there and increased her weightings in sectors such as energy, basic materials, and utilities, which tend to behave differently from New Economy tech, telecom, and health-care stocks. Because Raimondo invests in small U.S. startups, Hornstein avoids small caps and invests more of her money in large foreign stocks. "I feel a lot more confident knowing that my portfolio is tailored to move one way when my venture capital investments may be moving in another," Raimondo says.
To further reduce Raimondo's risk, Hornstein plans to cut her overall stock exposure in the near future. "Venture capital is highly correlated with the stock market in general," he says. "Our focus is to manage Gina's portfolio in the unlikely case that the overall stock market and the sectors she's exposed to do poorly." Although the normal stock allocation for someone of Raimondo's age and risk tolerance would be as high as 85% at Hornstein's firm, he wants hers to be less than half that.
While Hornstein recommends doing everything you can to minimize exposure to the industry you work in, some investors want to capitalize on their industry knowledge. One is Darin Gosda, senior vice-president at Betz Cos., a commercial real estate broker in Houston. Gosda has almost 40% of his assets in Houston real estate, not including his house. "I've been investing in real estate in Houston for 16 years, and I've never lost money," he says. "During my worst year I earned a 13% return and my best over 60%. None of my financial advisers have ever done as well for me in the stock market."
What planner would have the courage to tell Gosda to be more diversified? "We're uncomfortable with Darin's strategy, but he's been doing this for many years and has been very successful at it," says Marc Schindler, Gosda's adviser at Pivot Point Advisors in Bellaire, Tex. About all Schindler can do is avoid real estate stocks in Gosda's portfolio.
The problem with stories like Gosda's is that few individuals are as successful as he is investing in their own industries. "Seventy-five percent of professional money managers who invest for a living can't beat the market," says Ron Papanek, a market strategist at RiskMetrics Group (RMG), a New York financial risk analysis firm. "So what are you doing trying to pick stocks in your own industry? The average person just isn't that good of an investor."
Papanek's firm runs a free Web site, RiskGrades.com, that shows investors how much more volatile their portfolios become if they concentrate assets in their own industries. They can plug in the investments in their portfolios and the site will give them a grade—the higher the grade, the more volatile the portfolio. Concentrated industry-centric portfolios get the highest grades. That's before factoring in the much harder-to-quantify risk of losing one's job. The site also helps individuals who are designing their own portfolios figure out what stock sectors are least correlated with their industries.
For those who can't resist investing in their own industries, Papanek stresses that they should at least recognize that if they invest like this when they're young, it's easier to recover from a major loss. But investors approaching retirement can't afford to jeopardize their nest eggs. Other advisers actually plan around their clients' "play money." When clients of Evensky & Katz's McGrath insist on placing bets on their own industries, he asks them how much they can afford to lose and then tries to persuade them not to put more than 5% or 10% of their assets in that sector. "That usually satisfies their desire without putting their financial independence in jeopardy," he says.
Of course, some investors have no choice but to invest in their industries. Many executives get bonuses in the form of restricted stock or stock options they can't easily sell. So they're not only concentrated in their industries but in their employers, significantly amplifying their risk. There are potential solutions: An executive could buy a put option, a security that rises when the company stock falls. But companies may put restrictions on when an employee can do this, if they permit it at all. Buying a put option on an exchange-traded fund that tracks your industry is another idea. Of course, if your industry rises while your company's stock falls, you lose on both counts. The human capital riddle is never easy to solve.