Sunday 23 October 2016

The "Art" of Asset Allocation (Part 1)

These days I often question myself: should I rebalance my portfolio? Should I keep more cash? Less cash? Should I add bonds to my portfolio? While thinking through about my finances and asset allocation, I recalled some wealth management theory, which is what I would like to share here today and perhaps, see how I (and you) can apply it in real life.

Most of us earn and save from human capital to build financial capital over time to fund retirement. What is human capital? Theoretically, it is the present value of a person’s expected future earnings from salary, wages, bonuses, etc. It is a measure of one’s lifetime earning capacity. Therefore, the younger you are, the more human capital you have. Financial capital, then, is just the monetary value of your assets.

human vs fin capital.png
Pardon my rudimentary Paint drawing.

This is the expected relationship between human capital and financial capital. At any point in time, total wealth is the sum of the two. Of course, there could be unexpected events that disrupt this progression, for example, earnings risk as one could lose his job due to health, or changes in economic conditions. This earnings risk, however, can be reduced by saving more now to build financial capital more quickly and allow it to start compounding in value more. (You can refer to our earlier posts on savings!)

Now, the mistake that many people make in their asset allocation is that they often neglect this human capital, or perhaps take it for granted. What’s a better investment than just turning up at a certain place at a certain time for a number of hours, to receive a dividend at a fixed regular interval, which even steps up over time?

So, let’s say human capital is treated as another portfolio asset. Hypothetical Investor A has highly certain future income (stable job in the public sector?) and human capital. Financial capital, on the other hand, is relatively minimal because he is young and only started working 3 years ago. Thus, his human capital can be thought of as a low risk bond with regular coupon payments (salary), and his financial capital should be allocated to equity to balance out the risk-reward. The stability of his human capital mitigates the volatility of the stock market, while he retains the opportunity to grow his assets more quickly in the market.
As Hypothetical Investor A ages and financial capital becomes larger in relation to human capital, financial capital could be allocated toward lower risk fixed income and away from equity, as the focus now is to protect his financial capital. 

Let’s move on to Hypothetical Investor B, who is also young, but has uncertain future income (a sales job in the oil and gas sector?). Also, the income is highly correlated with the state of the economy (or the stock market) making for risky, equity-like human capital. Financial capital is minimal. In this case, human capital should be treated as... that’s right, equity! And financial capital should be allocated to fixed income investments. The worst scenario I can think of is Hypothetical Investor B, with a sales job in the oil and gas sector, being vested in Keppel Corp or SembMar stock as well. 

Anyway, as Hypothetical Investor B ages and financial capital becomes relatively larger, financial capital could first shift to equity as the portion of equity-like human capital declines over time and later start to shift back to fixed income. 

The last Hypothetical Investor C, is one with significant financial capital and human capital. His human capital is less risky than stocks, thus he can allocate financial capital to more risky equity investments. Then as he ages, he will need to reduce the equity in the financial capital to reduce the risk of his total wealth.

Which Investor’s profile do you think matches yours? This is something for me to think about too...

Wait. I’m forgetting something. What if I pass away prematurely? (Touch wood!) Omg, no more human capital, and financial capital is not enough to support my family for the rest of their lives! 

This is where insurance comes in. 

This post is getting too long, so stay tuned for my next, where I will be sharing more on my own asset allocation! Will also touch on why I chose term insurance. 

Cheers,
Yolohuat


Disclaimer: I don’t sell insurance :)

0 comments:

Post a Comment

Feel free to drop your comments here!