No Asset is an Island
Economic wealth consists of four different components. Each will have relative weights as you address risk, volatility and impact on your family as you move through your financial life. Human capital is your working capacity and holds a high relative weight in your younger years, diminishing as you move toward retirement. The next three will have low relative weights early and potentially grow over time. You have pension wealth. This may be Social Security, PERA, or a corporate pension program that will provide you with some sort of future systematic payout. Real estate wealth is an asset that for many, will increase in market value over time as well as build equity as you pay down mortgages. Real estate wealth may be in the form of your primary residence, or investment properties depending on if and how you want to utilize it in the distribution phase of your life. Finally, your financial capital is the money you have in a variety of vehicles inclusive of your IRA’s, 401K’s, trusts and brokerage accounts.
While economic wealth is made up of these four factors, it is important to understand that each inherently changes as our societal norms change. It is rare to see a person go to school, head into a career, work for the same company for 45 years, and retire with a pension as was common with the “Greatest Generation”. If you are fortunate to love what you do for a living, your human capital may continue to have positive value throughout most of your life. Defined benefit programs have become a minor part of pension wealth as defined contribution plans (401K, SEP, SIMPLE plans) have taken over. Studies show the millennials are less likely to purchase and hold primary real estate as compared to previous generations, their lives have become more transient around work. This fluidity of personal economic wealth needs to be intentionally managed much in the same way as we look at how to administer the complexities of water in the west. Bottom line – it ain’t easy!
Do the first three facets of economic wealth have a bigger impact on how you should look at your investment bucket than previously thought? Customary asset management looks at reducing volatility and risk management through diversification, asset allocation, hedging, or other traditional practices. A recent paper from Morningstar’s David Blanchett and Philip Straehl, entitled “No Portfolio Is An Island”, posits that we need to look at the a household’s total economic wealth in tandem to come up with a true picture for managing volatility, portfolio design, and life stage implementation. Their white paper goes into detail as to the need to design investment portfolios inclusive of your total wealth picture.
There was no better example of how this plays out than what happened to this valley in our recent recession. It was the perfect storm for realtors who were winding down their human capital contribution to their wealth in 2007 and 2008. Compound their timing of retirement with a heavy weighting in real estate, exposure to financial risk increased dramatically. Their Social Security or defined benefit program may have been stable, but if investment assets also included REITS (real estate investment trusts) as an “alternative investment” as part of a diversified portfolio, real estate over-weighted three areas of their economic wealth, and the recession wreaked havoc on lives. Risk management needs to look at your financial picture holistically. Look at your financial life from all four spheres of economic wealth and how to proactively manage the opportunities and risks inherent at different life stages.
We pay too much attention to what the talking heads say in the media and how our investment portfolios are doing compared to “benchmarks”. We can let fear or greed throw the financial capital portion of our financial lives out of whack if we are not mindful, acting like Lemmings and following the herd. Too much weight is put on the financial capital portion when in reality it is only a piece of your comprehensive wealth management program. When you review your investment portfolio, do it inclusive of the other three important parts of your economic wealth. How are you managing its relative weight in your overall financial picture for where you are at in your financial life stage and what your future goals are?