I have seen an extract that says: If financial wealth is limited and human capital is equity-like, a greater portion of financial wealth should be invested in the risk-free asset. As this investor’s financial wealth increases relative to human capital, a greater portion of financial wealth should be invested in the risky asset. Reading 13, practice problem 4i questions says: Sanchez is a corporate executive, exhibits moderate risk aversion and has income that is moderately correlated with risky asset returns. Discuss how the ratio of financial to human capital changes as Sanchez approaches retirement. The answer says: The amount of his financial capital increases over time as a result of returns to his existing financial wealth. The ratio of financial capital to human capital increases as Sanchez approaches retirement. The allocation to risky assets decreases over time. Which is correct? The extract says as financial wealth increases relative to human capital, increase investment in risky asset. While the question says as financial capital increases relative to human capital, decrease investment in risky asset.
Break it down:
If financial wealth is limited and human capital is equity-like, a greater portion of financial wealth should be invested in the risk-free asset. As this investor’s financial wealth increases relative to human capital, a greater portion of financial wealth should be invested in the risky asset.
In the question you provided, Sanchez is a corporate executive and being that he is an executive, you can assume that over time he’s allocating a significant amont of his ‘earnings’ into financial capital (excess capital over expenses).
Since his financial wealth becomes less limited over time, he does not necessarily have to keep his allocation of FC to the risk-free asset. Therefore it decreases over time.
Galli, you may have misread the answer to the question provided. CFAI answer to reading 13 practice problem 4i says: The ratio of financial capital to human capital increases as Sanchez approaches retirement. The allocation to risky assets decreases over time. However, the text says: as financial wealth increases relative to human capital, increase investment in risky asset. I am still confused as to which is correct, when financial capital increases relative to human capital, do we increase or decrease investment in risky asset? Can someone please verify.
I would say increase (that is if you really meant risky asset rather than risk-free asset).
when financial capital increases relative to human capital - you are looking at an older investor, typically.
HC highly correlated with equity (equity like) - it is risky. So you want to decrease your exposure to the risky asset on the FC side.
If HC is bond like - you want to increase exposure to the risky asset.
It is not a one size fits all, if I remember. you need to manage the risk of both the fc and the hc in a complete way.