When most investors think about asset allocation or diversifying their portfolio, they think of spreading their money around in stocks, bonds, real estate, commodities, etc. That is mostly correct.
Very few portfolios take into consideration what might be your biggest asset. If you are still working, your ability to get up and go to work each day is often overlooked. If you have a steady job with good job security, you can think of your employment income the way you would think of interest or dividends from a bond. In effect, you can treat it as part of the fixed income in your portfolio. If your employment situation isn't so certain, you can think of your paycheck as more like a stock, subject to increased volatility. This is called human capital. Is your job more like a stock or a bond?
You can use your financial capital to balance the mix of your human capital. Your financial capital consists of your investment assets. Stocks, bonds, annuities, rental property and the equity in your home are examples. (For related reading, see: 6 Ways to Boost Your Human Capital.)
Starting With More Human Capital Than Financial Capital
When you are young and getting started in the working world, you typically have a lot of human capital and less financial capital. So, you can generally afford to take more risks with your IRAs, 401(k)s and other investment accounts. As you get older, you have less and less human capital. When you retire, your human capital is gone. Since you will now be relying on various sources of retirement income, you have less ability to take risks, and it becomes important to consider lowering the risk profile of your financial capital. However, make sure to consider your guaranteed streams of income such as Social Security and pensions, which can also be treated like a fixed-income asset.
Most investors follow the rule of thumb that as they get older they gradually reduce the risk in their investment portfolio. This is done by reducing their exposure to stocks and increasing their exposure to bonds. If you consider your human capital in your overall allocation, you can probably afford to take a little more risk on the investment side of your portfolio—as long as you still have human capital to work with.
Something else you might want to think about as you allocate your assets: Some recent studies suggest that slightly increasing your exposure to stocks as you enter your retirement years can increase your odds of having a successful financial life—one where you have more money than breath. And isn't that the ultimate goal?
Now, of course, these are general thoughts and my opinion. How it might work in your case will obviously depend on your situation. But it just makes sense that if you are going to make the effort to allocate your assets, you should consider all of your assets.
(For more from this author, see: Balancing the Different Risks Investors Face.)