Wednesday, October 20, 2010

Your Other Portfolio - Part 2

In Your Other Portfolio Part One, we learned that your capabilities and prospects are an asset just as real as a stock or a bond. As you work you turn your capabilities and future prospects into cash which pays for your living expenses and is invested to fund your retirement and other priorities. Over the span of your life, the future amount your ‘human capital’ will earn falls while your financial capital grows.

But not all careers are made equal which affects the shape and risk profile of the future earnings you can expect. For example, let’s pretend that you’re a successful NASCAR driver. You can expect to earn quite a bit racing cars. But there’s always that fear gnawing in the back of your mind: what if I have a disabling crash? How long before I get too old for this?

So what do race car crashes have to do with financial planning? Simple: a race car driver runs three risks that make predicting his future cash inflows extremely difficult:
Risk of disability – this could happen, we don’t know when.
Short career span - very few drivers make it to 50, most are out by 40.
Unpredictable results - will you keep winning? For how long?

Financial experts describe stock investments as having ‘high beta’ when a stock’s price has a lot of variability, in other words, its future is very uncertain. Likewise, a person whose future earnings are unpredictable can be said to have a career with a high ‘beta’. By contrast, someone with a job as a public school teacher has much greater income certainty, sometimes even down to the precise date of their retirement.

So if you do have a career with a high level of uncertainty it makes sense to use your financial choices to mitigate the risks your career presents you. Some of these are obvious:

1. Higher chance of early death or disability? Make sure you have enough insurance to cover these risks.
2. Short career life or unpredictable earnings? Save more to cover many more years of low or no earnings.

But even after you’ve gotten the insurance and socked away quite a bit of cash, there’s another level of planning that you should consider: risk balancing. You need to adjust your investment portfolio’s risk profile downward to reflect the high levels of career risk that you face. In other words, because your career is unpredictable, your investments should be more predictable. By doing this you can lower the chance that you find yourself ‘short’ due to circumstances.

Of course the opposite applies for those with very predictable career and earnings paths. In their case, because their career risk is low and they have a long career horizon, they can afford to save less and invest in assets with higher return and risk profiles and still achieve their financial goals.

At the end of the day your career, your house and your financial assets are all part of your wealth. It makes sense to think of them together and to make sure that each component complements the others in the achievement of your personal and financial goals.

Recognizing and balancing all of your major sources of uncertainty is the best way to get into the Financial Winner’s Circle.

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