Most financial commentators suggest that asset allocation is the main thing to focus on when constructing your investment portfolio.
Where you invest your money asset-wise will determine your outcomes more than any other aspect.
For example: if you choose to invest all your money in property and the property market enters a ten-year slump, then it does not matter too much what is in your property basket, you are going to suffer.
If stock-markets perform well and the property market performs badly, then it is possible, indeed likely, you would be better off in a basket of below average shares, than a basket of above average properties.
That is why asset allocation and diversification are so heavily linked.
If you diversify successfully and use a mixed bag of different asset-types, such as shares, government bonds, company bonds, property, commodities, and cash, you will help to reduce the risk on your portfolio and give yourself every chance of a steady return.
The evidence from research shows that it is this top-level position which makes the biggest difference to your future return.
This means commentators and leading financial experts typically recommend varying allocations for different investors. High risk investor? Then have more allocated to high-risk areas such as shares. Low risk investor, then less in shares, more in bonds and cash – and so on.
The typical relationship is one where you base your allocation on your risk profile.
This is too simplistic and ignores something very fundamental, which we can call your human capital
To explain, think of it like this. Two people want to invest £400,000; both are age 55 and both classify themselves as ‘medium risk’ They broadly have the same aims.
Therefore, they should plump for the same portfolio with the same asset allocation.
But their human capital positions could be quite different.
For example, dig further, and we find that one is a University Professor, and the other is a property developer.
The University Professor has a gilt-edge final-salary pension with lots of guarantees attached. They are, in effect, already holding significant “bond-like” income within their pension structure. Income of a decent level, guaranteed for life, protected to some extent against inflation.
They have little exposure to economic woes with this substantial pension arrangement; therefore, they can invest with more aggression with their actual capital (£400,000) because their human capital provides a balancing effect. They can offset this against higher allocations in shares and property.
The property developer has – through their business – all their eggs in the property basket, so when it comes to their actual capital (£400,000) they do not really want any more invested (allocated) into property.
The chances are that their property development business is, to some extent, aligned to the general economy, therefore they are exposed in broad ways to an economic slump. Their “human capital” element is much riskier than the University Professor’s.
Arguably, they should invest their £400,000 differently, possibly very differently.
Our view is that all investors should think like this and make decisions factoring in their human capital. Carefully considering their work and lifestyle, assessing what they do and how this influences the overall asset allocation, beyond the portfolio.
Trevor Downing FPMI FPFS
