human capital and allocation to equities

This is from CFAI 2011 past paper, question 5C. Colleen is 32 years old and worked as an equity analyst for 10 years. Can someone please explain the answer:

  1. Given she is young, why should she have a lower allocation to equities? Since she has a long time horizon, shouldn’t she invest in equities? 2. Since she has a large amount of human capital relative to her financial capital, why should she have a lower allocation to equities?

She is working in equity analysis therefore her salary (and therefore her human capital) is already correlated to equity markets, she should therefore diversify her investable assets away from stocks.

HC cannot be highly correlated with FC. Hence why you use a different asset class to search for risk.

Okay so i understand that HC that is correlated with equity markets means less allocation to stocks. But how does age come into it, because the answer says “given she is young”? If you are young, shouldn’t you allocate more to equities?

Irrespective of the age the main aim of the portfolio should be to strike a balance between risk and returns. Higher correlation will increase the risk. And assuming if she were to continue at her workplace no matter how much long time horizon she has she will put significant risk while establishing a stable portfolio if invested in equity.

Imagine a case where she looses her job and at the same time her FC underperforms just because she has put everything into equity thinking her age is low. In this scenario she will tend to loose big time. So balanced out by investing FC into debtlike investment.

As she gets older, and her job security improves or becomes less correlated with the equity market, the portfolio’s equity allocation may go up to levels on par with other investors at her age, not higher. That’s the only exception between age and equity allocation rule, seeing as it came from a low base, but then it declines again near retirement. So It’s more of an inverted U-shape.

Are those two questions separate? Both questions have the same answer so isn’t that a bit repetitive?

Maybe the answer to the first question is that her job is highly correlated to the markets.

In regards to the second answer, you could mention that the HC is considered risky as opposed to risk free.

Since when is HC risk free?

Maybe If you are retired and were in a DB plan ? laugh

We generally assume that HC falls to zero on retirement. Unless specified otherwise.

And a DB plan is not exactly risk-free.

Reading 12, section 1, case #1

“assume that there is no uncertainty about the investor’s annual income”

Of course this is theoretical.

Even if, this is just one of the risk components. Not all questions gives you the rfr and assumes labor income is risk-free. The forumla in Schweser echoes my view.

You also have mortality risk, which determines your life insurance premium.