How to evaluate your total financial life

Christine Benz, Morningstar's director of personal finance, believes that more idiosyncratic your human and non-portfolio financial capital, the more 'vanilla' your portfolio should be.
By Morningstar |  13-09-17 | 

The case for using simplified, ultra-diversified investment products is strong if  you have something complicated going on with the rest of your financial life,  either with your human capital or your total financial portfolio.

Maybe you receive a big share of your compensation in the stock of your employer, for example, or you have sunk a lot of your money into property. The more such idiosyncratic risk factors you have, the stronger the case for keeping your investment portfolio vanilla and hyper-diversified.

Morningstar Investment Management researchers David Blanchett and Philip Straehl addressed such idiosyncratic risk factors in their research paper, No Portfolio Is an Island. They wrote that investors would do well to think of their investment portfolios as their "completer portfolios"--to offset risky bets in the rest of their financial lives. For example, the person with a job in the technology sector should avoid ramping up exposure to companies in that same sector. The person with a lot of fixed-income assets should skip the dedicated debt funds. And so on.

That's a valuable line of thinking. But I'd suggest that you could interpret the research even more broadly.

Take stock of your whole financial life--your human capital as well as any assets you own in addition to your investment portfolio--a stake in your brother's company or a real estate property which you have given on rent, for example. The quirkier your nonportfolio assets, the more vanilla and stripped down your investment portfolio ought to be.

That doesn't mean that you necessarily ought to be more conservative from an asset allocation standpoint. If you're a 35-year-old entrepreneur, you need enough of a safe cushion in your investment portfolio to tide you through weak periods in your business, but you also need ample stock exposure in your retirement portfolio to give you some growth in case your business doesn't take off. Within that equity exposure, however, it's valuable to avoid big bets on individual securities or sectors, arcane investment strategies and niche investment products. Your business is your high-risk asset; your portfolio doesn't need to be a high-wire act, too.

There are several reasons this makes sense.

As discussed above, maintaining a broadly diversified, highly liquid investment portfolio can ensure that you're not doubling down on some of the risks in your broad financial portfolio. The liquidity of a broadly diversified portfolio--say, a basket of equity and debt funds --can also serve as an antidote to the nonportfolio assets, which are usually illiquid. Additionally, having a more complicated financial life-- owning a small business, for example--likely means that you have less time to devote to your investment portfolio. Holding simple building block investments helps ensure that your portfolio doesn't need a lot of monitoring on an ongoing basis.

As you survey your total financial life, ask yourself these questions.

Do you own a small business?

It's not unusual for small-business owners to invest the majority of their net worth in their businesses. That has implications for asset allocation, of course; small-business owners may have volatile earnings. All else equal, they'd want to hold more safe securities than non-business owners at the same life stage.

In addition, small-business owners should aim for extremely well-diversified exposure within asset classes, to help offset the huge company-specific risks inherent in their business ownership. Not only should the portfolio downplay the industry in which the small business operates, but it should avoid big sector-specific and stock-specific risks in general.

Are you incentivized through company stock?

In a similar vein, many employees are incentivized through ownership stakes in their firms; if the business does well, those positions can take up a sizable share of their net worth. Morningstar Investment Management's head of retirement research David Blanchett has said that the ideal percentage of employer stock in a portfolio is 0%. Nonetheless, the employee may face tax consequences to unwind their concentrated equity holdings. For that reason, employees with large weightings in their employer's equity should work to neutralize those exposures by keeping the rest of their portfolios scrupulously well diversified.

As with the small-business owner, it makes sense to downplay the sector in which your company resides, as well as big bets on companies and industries within your investment portfolio.

Are you close to retirement or retired?

Everyone knows about the virtue of lining up more safe assets as retirement approaches. But retirees still need ample equity exposure, to help improve their portfolios' longevity and offset inflation. They need equity exposure to ensure that they don’t run through their portfolio prematurely. What retirees don't need, however, are big bets on specific stocks or sectors, especially if their plan doesn't leave a high margin for error. Even though well-chosen individual stocks have the potential to boost returns well above the broad market's, they also have the potential to results well below the market's.

Does real estate represent a large share of your net worth?

In many households, an ownership stake in residential real estate is the largest single asset. During a real estate crisis the value of your home would drop and it might happen at the same time your investment portfolio does too. And while stakes in rental properties can provide an attractive source of cash flow, like any illiquid asset they can also be a source of risk if the investor needs to sell in a pinch. At a minimum, investors with a sizable share of their net worth in real estate—their own homes or rental properties--should downplay real estate-specific investments in their portfolios. They should also bear in mind that some fund portfolios contain some real estate exposure too.

Did you take into account human capital?

Blanchett, head of retirement research at Morningstar Investment Management, advises individuals to factor in human capital to arrive at a holistic approach to asset allocation. It is the accumulated wages of a lifetime, given earnings and skills.

Since age, health, education, occupation, industry and experience, among other factors, all affect human capital, it is a unique asset. If you have risky human capital, you should be more conservative in your portfolio, and vice versa. Different professions and different jobs carry different amounts of risk, when they are being quantified in terms of human capital. For instance, government jobs or teaching jobs are much safer than that of a professional football player.

The goal of using the concept of human capital is to get a truer sense of how to balance the other assets overall. You can read more on human capital here.

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AshaKanta Sharma
Sep 14 2017 10:27 PM
Great Explained.
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