human capital and asset allocation

Let me know if this insight I had makes sense to you. (I haven’t looked to see if I am the first to have it, likely not.)

CFA texts model human capital as equity-like (e.g. a broker’s income) or bond-like (e.g. a tenured professor’s salary) and advise the stocks/bonds allocation accordingly. For example, even if you are young with plenty of time to recover from a market crash, you should allocate mostly to bonds if your income depends on the health of the economy and of stock market in particular. In CFA forums, I often see that a lot of candidates have problems with this advice, and now I think I know why.

No matter how your future cash flows from your job are realized, they are still CASH. Even if they are highly variable, CFA texts are mistaken to treat them like equity. They should treat all human capital as a bond. Depending on the nature, it could be a floater (for a stock broker), a fixed interest rate bond (for a tenured professor), a callable bond (for someone likely to die soon(*)) and so on. The price of the bond is not decided by prevailing interest rates (like treasury rates) but rather by the market value of the human capital and macro conditions.

Consider two different categories of people with variable incomes. A gifted trader or a salesman has a human capital like a floating bond with a high floor and a high ceiling and should always trade at a premium. OTOH a farm worker or a seasonal teenage emplyee in retail has a human capital like a floating bond with a low floor and a low ceiling and should always trade at a premium. To be precise, it’s not so much what they do as it is how much cash they can and will put away for investment as opposed to personal consumption, taxes, savings etc. So I will concede that a spendthrift salesman’s capital should trade at a discount while a contractor who saves exvery excess penny can trade close to par or at a premium.

To actually compute the value of the human capital, model the expected cash flows and discount them back based on certainty of realization (like we do for venture cpital returns.) Now treat this cash figure as your current allocation to fixed income, and decide your equity allocation based on some variation of the 60/40 rule or some combination of stocks+bonds+real assets. As Meb Faber has discussed in his latest eBook, the exact composition and rebalancing strategy hardly matters as long as you invest in some of each.

For example, if you DCA monthly into 100% equities, you should treat it as a rebalancing - increasing your equity allocation and reducing your fixed income allocation. If you are young, 100% monthly buys of stocks may be actually less risky for you than a 60/40 monthly allocation, simply because they reduce your already high fixed income exposure (even if your actual bond holdings are zero.)

(*) A morbid thought: all human capital bonds are callable, just the call dates are unknown and we like to think them as being far into the future.

You have not considered unemployment or long-term disability. These two possibilities, for someone with no insurance or meaningful benefits or social support, are what make the trader’s salary, and most individuals’ salary equity like, or at least similar to a balanced exposure. The calculation of human capital should incorporate these two possibilities leading to a higher discount rate than bonds/cash.