Most of what you read in magazines about financial planning is wrong. Those formulas where you subtract your age from 100 to get your suggested stock allocation? The asset pie charts that will supposedly shepherd you safely through your golden years? They ignore the most important element shaping your finances—something that should be factored into every aspect of your investment strategy: your career, or what financial types loosely call human capital. After all, for most people their job is their largest financial asset, and a salary provides the bulk of their wealth.
The moment human capital is included, however, complex questions arise. How, for instance, should the investment strategy of a tenured professor differ from that of an auto worker in a factory that may soon be closed? Should an executive at an oil company invest in energy stocks after they've had such a strong run?
What about brokers who used to work at Bear Stearns (BSC) before its meltdown? Should they have owned financial-services stocks or even owned stocks at all when their livelihoods depended so much on the stock market's moves?
The problem is how to turn your career into something quantifiable that can fit into a plan. One suggestion from financial researcher Ibbotson Associates is to think of your job as a type of financial security. "Years ago we had a meeting at Ibbotson with all these legends of finance and Nobel prize winners, such as Harry Markowitz and Daniel Kahneman, in which we debated what kind of security the average person's human capital is like," says Thomas Idzorek, Ibbotson's director of research. "We concluded it was like a junk bond. When times are good, it pays a stable income stream and trades like a bond. Then there's a hiccup, and it becomes volatile and trades like a stock."
To be more precise, Ibbotson judges the average person's human capital to be 70% like a bond and 30% like a stock. "The human capital of a tenured university professor with a stable income may be more like a portfolio that is 80% bonds and 20% stocks," Idzorek says. "Someone working in financial services, whose salary and bonus depend largely on the stock market, might be 50% bonds and 50% stocks." All other things being equal, the tenured professor should be investing more aggressively than the stockbroker.
Financial planners offer various solutions to the human capital conundrum. Adviser Matthew McGrath, a principal at Evensky & Katz Wealth Management in Coral Gables, Fla., factors it into the cash reserves he recommends clients keep to cover expenses should they lose their jobs. "If both spouses are at stable jobs in stable industries, maybe you need only emergency reserves to cover three months' worth of expected expenses," he says. "But if only one spouse is working you probably need six months' worth."
Some of McGrath's clients are self-employed business owners in cyclical industries such as retailing and real estate. Their incomes can vary greatly every year and even month to month. "These people often have a lot of illiquid assets that can't cover all their daily expenses," he says. "We get an estimate of their expected expenses for the next two years and put that in cash, money market accounts, and ultrashort-term bonds." Generally speaking, he puts the first year's worth of expenses in cash and the second year in slightly higher-yielding bonds.
McGrath says having such a cash cushion enables him to invest the rest of a client's assets more aggressively in traditional stocks and bonds. "The cash reserve separates clients psychologically from the market," he says. "They don't have to worry about what the markets are doing every day because they know their expenses are covered."
Some planners tailor the remainder of a client's portfolio to the industry she's working in, reducing or cutting exposure to certain sectors. "We replicate a global index of thousands of stocks but tailor it for the individual,"