Consider your human capital

(MoneyWatch) One of the most persistent mistakes investors make, often with devastating consequences, is the failure to consider their human (labor) capital when constructing their portfolios. In fact, while human capital can dominate a portfolio (especially in the case of younger workers who have limited financial capital), it's an often-ignored component of an individual's wealth. The reason for this oversight is that human capital doesn't appear on any balance sheet. The problem is so pervasive that, in my experience, it's the rare financial advisor that even considers human capital in their asset allocation recommendations.

What you're worth

We can define human capital as the ability to earn income. Not only do we need to define the magnitude of one's human capital, but we also need to consider its variability. Some businesses and professions are highly cyclical, and are thus highly correlated to the economic cycle and the risks of owning stocks. Good examples of professions that might fall into the high correlation category are automobile and construction workers. Other professions have very stable incomes as their ability to generate income has little or no correlation to the economic cycle. Good examples of occupations that might fall into the low correlation category are health care professionals and tenured professors.

Since one of the keys to properly constructing a portfolio is to own assets with low correlation, all other things being equal, investors whose intellectual capital is highly correlated to the economic cycle should consider taking less equity risk than those whose intellectual capital has low correlation to equity risks. The reason is that an investor would not want the following situation to occur: A weak economy causes the market to drop and the investor to lose his job. In turn, this causes him to have to sell financial assets, at low prices, to meet expenses. Given this simple logic, we are left with the puzzle of explaining why so many employees concentrate their wealth by holding the stock of their employer? I'll offer a few explanations.

  • Confusing the familiar with the safe: Employees are often overconfident about the outlook for their firm. This translates into concentrating assets.
  • Overconfidence: Overconfidence is a well-documented human trait, leading to poor investment decisions. And familiarity adds fuel to overconfidence problem, causing investors to be overly optimistic about the employer's prospects.
  • Treating the likely as certain and the unlikely as impossible: Despite such recent examples as Enron, WorldCom, Lehman Brothers and Bear Stearns investors think that such disasters happen to other people and other companies, not them.
All the eggs is one basket

Another cause for the failure to diversify we can call "rearview mirror investing". The study "Excessive Extrapolation and the Allocation of 401(k) Accounts to Company Stock" found that strong past performance of an employer's stock leads to overconfidence with respect to future performance. The past performance is simply extrapolated into the future. However, great past performance usually results in high valuations. Thus, not surprisingly, participants who overweighted based on past performance earned below average returns .

The field of behavioral finance provides us with other possible explanations. The authors of the study "Human Capital and Behavioral Biases: Why Investors don't Diversify Enough" offered several other behavioral explanations for the failure to diversify:

  • Endorsement effect: Participants in 401(k) plans are influenced by an employer match in company stock -- they consider the match in stock as an endorsement, taking it as a positive signal to invest in the company. The same thing is true of stock grants and stock options.
  • Cognitive dissonance: We all want to feel good about our career choices and our employer. That leads to choosing to believe that a firm's prospects are bright. Choosing not to believe leads to angst and self-doubt. This leads to an overly optimistic assessment of the firm's prospects, and concentration.
  • Appeal to authority: Many employees tend to thoughtlessly obey or believe those they regard in positions of authority. Thus, they overweight optimistic statements by executives about the company.
  • Choice overload: Various studies have shown that participants are often overwhelmed with information regarding choices for their retirement plans. An easy way out is to take the familiar option, company stock.
  • Commitment bias: Selling company stock can be seen as a sign of disloyalty.
  • Confirmation bias: We have the tendency to overweight evidence that confirms our views and ignore evidence that is contrary.
  • Herding: Few people have the ability to fight the herd, they would rather follow it. One reason is that they are concerned about how others will assess their ability to make good decisions. Thus, the fact that other employees own large positions in company stock influences their decision to do so.
  • Regret aversion: We are concerned with the regret we will feel if we make a decision we will later regret. This leads to employees maintaining concentrated positions in order to avoid the emotion they would feel if the stock eventually raises sharply.
Assets: Not from concentrate

The sad fact is that so many people fail to consider their human capital when developing their financial plan. The fact that as human beings we are all subject to making behavioral mistakes compounds the problem, leading to excessive concentration of our assets in the stock of our employer. Thousands of employees have made this mistake, often with devastating consequences, with life savings being virtually wiped out when companies like Enron went bankrupt. You don't have to make this type mistake. And if you have concentrated your assets, hopefully, this will serve as a wakeup call. It's not too late to correct a mistake, until it is.

Robert R. Johnson and Stephen M. Horan, "Human Capital and Behavioral Biases: Why Investors don't Diversify Enough," Journal of Wealth Management, Summer 2013.

Image courtesy of Taxbrackets.org. 

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.