Connecting Your Career With Your Financial Capital
Part 3: Human Capital Risks and Expected Investment Rewards
Last month we talked about how entrepreneurial and other high-energy professional careers are often highly correlated with stock market and economic downturns. In other words, when the markets and/or economy plummet, odds are both your investment portfolio and your career earning power may be tanking in tandem. Read about How Smart Investors Factor in Themselves as an Asset.
Tilting more of your investments away from equity (stock) risk doesn’t have to leave your portfolio gasping for power. It’s possible to have your super-safe rated Tesla Model S P100D, and still enjoy its “ludicrous mode” of 0 to 60 mph in 2.7 seconds.
The trick is to diversify your portfolio risks by powering up the smaller dose of equity you retain and adding certain low-correlated alternatives to the portfolio.
Here’s how that looks:
- Tilt your equity toward higher expected returns: Allocate a portion of the remaining equity risk among the asset classes that exhibit higher expected returns than the overall market offers (which also means higher risks). Think small-cap and value companies.
- Bulk up on bonds: Begin by owning a bigger slice of less-risky investments in your portfolio – i.e., an increased allocation to high-quality bonds.
- Include alternatives: Build in an allocation to “consumer friendly” alternatives (i.e., relatively low-cost, evidence-based funds with clear disclosures).
This potent mix lets you build a sturdy safety net so, should worse come to worst in your career or business, you can preserve your human capital and live to fight another day. At the same time, you retain a concentrated degree of higher-expected return holdings, so you can still expect to accumulate additional wealth toward achieving your long-term goals.
Putting Diversification to Work for You
Again, to add insult to injury during troubled economies, your human capital risks may be realized at the same time your investments are heading south. For example, an illiquid company stake, valued stock options and similar benefits can dry up during market downturns.
The pain is aggravated if your personal wealth is overly concentrated in the same markets in which your business is operating. Unlike your relative ability to control the course of your own career, as an investor, you have little or no control over global economy and geopolitical risks, both of which can collectively or individually spell the unexpected end of the road for any security you may hold.
This is especially the case if large swaths of your wealth are held in illiquid holdings such as your employer’s company stock or ownership of your business or practice. You can’t know the unknowable, so there’s not much you can do to prevent the day that your company announces its stock has plummeted 44 percent due to an internal or external event nobody could predict. Or, a disruptive technology company has just usurped your business’ competitive advantage. Then what? Suddenly, your investment vehicle has stalled, if not gone into reverse.
In short, holding too much company stock or similarly over-concentrated holdings can create a ticking time bomb in your personal investment portfolio, waiting to explode at the same time your business and/or career may also be on the line. (Think Enron and Arthur Andersen.)
The fix is to properly diversify your personal wealth around the world and away from your company holdings. This is sound advice for almost every investor, and especially for those who face high levels of concentrated, human capital risk.
A Deeper Dive Into Diversification
But what does “proper” diversification look like? It means a lot more than just buying a lot of securities and assuming your risks are spread around. You also need to hold a lot of different sources of expected returns from around the world.
We learn from the newly updated version of Larry Swedroe’s and Kevin Grogan’s book, “Reducing the Risk of Black Swans,” investors do not need to rely as heavily on owning large equity allocations (“beta,” in finance-speak) to generate the long-term returns they require to meet their investment goals. Instead, Swedroe and Grogan propose that investors should seek to harvest returns from other risk factors to seek equity-like returns with less exposure to equity bear markets.
Their advice seeks to take advantage of the investment strategies available to gather alternative return premia by using a genuine multi-factor strategy now accessible to retail investors. They rigorously present a case for allocating your portfolio to a variety of academically validated strategies with successful live track records. These sources of returns have exhibited uncorrelated expected returns with one another and with traditional portfolio components such as equities and bonds. The investor’s resulting portfolio has the potential to deliver equity-like returns over their investing lifetime, with what Swedroe and Grogan demonstrate to have little dependence on owning company stocks outright in a portfolio.
Thus the data demonstrates: Investors with large exposure to the market’s whims can benefit from including large-cap value, small-cap, and small-cap value companies within U.S., international and emerging markets; publicly traded real estate; alternative lending, reinsurance, volatility, style premia and time-series momentum as investments with their personal portfolio. To temper the concentrated equity and equity-like risks you’re incorporating, the bond portion of a well-diversified portfolio might include five-year Treasury notes or other high quality, government obligations like municipal bonds.
It’s also worth considering how you’re implementing these allocations. To minimize unnecessary trading frictions that can derail an otherwise solid strategy, we suggest turning to passively managed funds employing an evidence-based philosophy with relatively low management fees. Avoid actively managed stock-pickers or market trend-chasers. Skip the mind-bending complexity of hedge funds, private equity or non-traded REITs. In addition to their high costs and complexity, the research shows they have not delivered on their promise of higher risk-adjusted returns. If anything, the opposite has been true. By choosing the more consumer-friendly structures and fees of mutual funds, you stand a better chance of understanding what you own, why you own it, and how it’s supporting your personal goals.
Granted, a low-cost, passively managed and globally diversified investment portfolio may not have the same curb appeal as a souped-up stock option, high flying hedge fund or real estate venture. But especially if you power up your solid portfolio as described above, it’s far more likely to convey you adeptly to your desired destination.