Your Biggest Asset: Your Human Capital

(click for full size image)
(click for full size image)

Yes, financial capital such as stocks, bonds, and alternatives are important assets. But, the most important asset in your portfolio is probably you: your human capital.

Economists often define human capital simply as the net present value of lifetime earnings. A recent estimate pegged the total human capital in the United States at $700 trillion. Compare that to investment portfolios of $45 trillion. Actually though, human capital is much greater than $700 trillion. It’s the sum total of competencies, knowledge, social and personality attributes, including creativity that produce economic value. It is seen in many venues including the workplace, homemaking and volunteering.

We certainly have more control over our human capital than the financial markets. We can switch jobs, obtain graduate degrees, work more (or less), become an independent contractor, or start a business. In the long run, an entrepreneur, for example, may greatly increase their financial capital as a result of investing in themselves and their business at an early age, thereby increasing their income from and equity in the business for years to come.

Many financial advisers focus only on wealth, the financial capital portion of the assets, for financial independence (retirement) planning. They may neglect income, expenses and cash flow. As John Wasik in the WSJ put it recently, “Figuring human capital into a prudent financial plan requires attention to detail that most financial advisers may not be able to handle.”

At DWM, we focus on both human capital and financial capital. We believe that a person’s financial independence or well-being depends not only on wealth, but their income and consumption of goods and leisure over her entire lifetime. The planning starts with a discussion of the client’s goals, their wants, their needs, and their wishes. Human capital comes first and the portfolio management follows. Every part of the detailed process is important, including cash flow management, financial independence planning, tax planning, risk management planning, estate planning, and portfolio management.

Occupations can have a large impact on the investment strategy of a client. A tenured professor, for example, with an excellent job and a well-funded pension program, can likely take more risks. His job is almost like a stable bond investment and hence, he can withstand more risk with his financial capital. Jobs with uncertain futures or owners of start-up businesses might be characterized as risky stocks. Hence, those people should dial down the risk of their financial assets. Lastly, someone who has a great job in one industry should consider diversifying their investments away from that industry so as not to put all of their “eggs” (both human and financial capital) into one basket.

Please note that the chart above does not show human capital at zero at the theoretical time of retirement. The fact is that most Americans in their 60s, 70s, 80s and beyond still have a substantial amount of human capital. This capital might be used to produce income. A recent Gallup survey shows that the traditional notion of retiring at age 65 is disappearing. 37% of respondents said they plan to work past age 65 – a sharp increase from 14% in 1995. In addition, many are employing their human capital, without pay, to make the world a better place. For many of our DWM clients, it’s one of their long-term goals.

Yes, your financial capital is important, but don’t neglect the importance of your human capital. For most of your life, it is likely your most important asset. And, even when you reach financial independence, your human capital can still be a powerful asset for decades to come.

At DWM, we understand not only financial capital but also the importance of human capital. If you’d like to discuss it more, please give us a call.

Concentrated Positions: Don’t Let a Torpedo Sink Your Hard-Earned Ship!

No torpedos

One of the many things we do when a prospect comes to us is analyze their current portfolio. We do this so we can assess the current risks in their portfolio that they may not be aware of and identify ways to minimize those risks, thereby getting the overall portfolio working for them, in a way that is in line with their particular risk tolerance.

We see many issues when analyzing portfolios, including, but not limited to:

  • asset allocation that is much riskier than their tolerance
  • lack of multi-asset class benefits by using only one or two asset classes (e.g. 100% equities / no fixed income / no alternatives)
  • heavy cash exposure – we often hear from people that they build up cash as they are hesitant to make a decision on how to invest it. Unfortunately, with cash returning about 0.001% these days it creates a huge drag on the portfolio.
  • the use of securities with high expenses (e.g. variable annuities (typically over 3.5% in expenses) or front-load mutual funds (may charge 5% up-front))
  • management fees that are higher than industry standards – we’ve seen people with significant size portfolios paying over 2% – that’s crazy!

We could do a blog on each one of these issues, but this week the focus will be on concentrated position risk.

So what is a concentrated position? It is a held position (typically equity) that makes up a substantial part (20% or more)

of an investor’s overall portfolio. A common example is a stock inherited from a grandparent. Another situation that we often see is a concentrated position risk stemming from a client’s company stock.

Some public companies offer many ways for the employee to get company stock. Here are just a few examples: restricted stock grants, ESOP programs, deferred comp programs, stock options, company stock within the company’s 401k plan, etc. Many people don’t realize how much these positions may have grown over time or, because of “bucket mentality”, they don’t even think of it as part of the overall portfolio. But they should.

In a recent meeting with a prospect, we identified that her company stock made up close to 30% of her overall portfolio. She wasn’t aware that her position was anywhere near this percentage until we pointed it out, but like many people she didn’t seem too concerned at first.

Here’s the problem: the major risk associated with such a portfolio is a lack of diversification; a concentrated position makes a large portion of the investor’s wealth dependent upon the performance of one particular stock. At DWM, we also call concentrated position risk ‘torpedo risk’, because that’s what a concentrated position can do to your whole portfolio, and hence your overall financial plan. It can hit and sink it just like a torpedo- not good. People tend to think this won’t happen to them, but so did the former employees of Worldcom and Enron.

Don’t let ‘torpedo risk’ from a concentrated position ruin your portfolio and/or financial future. A good rule of thumb is to keep all company-specific positions to less than 6% of your overall portfolio value, if possible.

Of course, there may be reasons for keeping a concentrated position such as restricted stock/options that follow vesting timelines, emotional attachment, low cost basis tax concerns, trading volume concerns, etc. An advisor like DWM can help you work through those issues via different strategies (e.g. dollar-cost averaging out, “collars” and other derivatives strategies, prepaid variable delivery forward contracts, exchange funds, etc.) and help you put together a portfolio that’s working for you, free of unnecessary risk and capable of meeting your long-term goals.

Housing is Hot: Time to Jump in?

dream houseHouse prices rose 9.3% in the 12 months ended February 2013. So says the Case-Shiller 20-City Composite. This was the highest growth rate since 2006. Some communities are seeing double digit gains; particularly those hardest hit earlier. Phoenix had a 23% twelve-month increase, San Francisco 19%, Las Vegas 18% and Atlanta 17%. Inventories of available homes are dropping- to less than three months supply in some of the hottest markets.

Certainly, the Fed has had a big hand in the recovery. Lower interest rates have made housing comparatively a more attractive asset. And, lower mortgage rates have created urgency for buyers. They want to own a home for many financial reasons, the most important of which, according to a recent Gallup poll is the hope to make a “good investment that appreciates in value.”

Yet, despite the recent run-up in prices, Robert Shiller, co-creator of the Case-Shiller Index, remains cautious about the long-term investment value of houses.

Over the last 100 years, house prices have increased only 0.2% per year, in real terms (after subtracting inflation). Yes, of course, house prices continue to rise. If inflation continues at the current 2.5% rate, a home selling for $400,000 today might sell for around $500,000 in ten years. Even though the price is up, the real value (in terms of purchasing power) is unchanged. Investing in housing is not like investing in stocks. Successful businesses should grow over time and so should their stock prices. Housing, on the other hand, declines over time, unless the owner pays for maintenance and improvements.

Furthermore, Dr. Shiller believes that the Fed’s quantitative easing (“QE”) has produced a “totally artificial real estate economy.” What would happen if 30 year fixed interest rates were 6% instead of 3.5%? Buyers would have their purchasing power reduced significantly. At today’s rates, $1,800 per month would cover principal and interest on a $400,000 mortgage. If rates were 6%, the same $1,800 would only fund a $300,000 mortgage. Assuming that individual had $100,000 as a down payment and rates were 6% instead of 3.5%, they could only afford a $400,000 house instead of one that was $500,000.

In addition, economic and demographic changes may severely impair the value of the house when it is time to sell. In the 19th century, housing was built near factories and warehouses. In the early 20th century, houses were built around streetcar routes. The suburbs started to boom in the 1950s when the Interstate Highway system came. Today, there is a trend toward walk-able urban areas and away from distant suburbs. In addition, aging baby boomers are creating demand for more continuing care retirement communities. So, the value of your house ten or twenty years may be impacted not only by inflation and mortgage interest rates but also whether your house is still fashionable. As Dr. Shiller points out: “Today’s dream house may not be tomorrow’s.”

There are many good reasons to buy a house. Most people live in their house for many years to build equity, receive tax deducations, and to live the American dream. That’s wonderful. Now may be the best time to act and lock in an ultra low mortgage.

However, for those of you considering buying principally because your house will be a “good investment that appreciates in value”, you may want to think again. History and changing economic and demographic conditions aren’t on your side.