How to Think Smarter About Risk
Too many investors may be taking big chances with their money because they aren't considering the most important asset of all: themselves
By MOSHE A. MILEVSKY
Sit back for a moment and ponder something unpleasant: How would a large, sustained drop in the stock market affect your personal finances? More specifically, imagine the Dow Jones Industrial Average hitting 6500—its March 2009 level—and staying there.Journal Report
Read the complete Wealth Adviser report.It will depend on the person, of course. Earnings in some professions are tightly linked to the stock market—an investment banker, say, or portfolio manager or financial adviser—while others, such as hospital nurses or tenured professors, are relatively immune to these zigs and zags. Most people will fall somewhere in between.
Consider this an exercise in personal risk management. It isn't intended to gauge whether you believe the stock market will test those levels again, and I'm not asking whether you are bullish or bearish. That is not what personal risk management is about, even if it is how most people practice it. The issue here is: If the bear returns for a prolonged visit, regardless of your subjective view of these odds, how would it affect your current and future earning power? And—more important—are you properly considering it when creating your investment portfolio?
I doubt it. In fact, I worry that one of the problems plaguing both investors and their financial advisers is that asset-allocation decisions are based excessively on how people feel (risk-averse or risk-tolerant) and what they believe (bullish or bearish about the stock market) as opposed to how much risk their personal balance sheets can tolerate.
To put it in even more-basic terms: As part of any asset-allocation strategy, you need to determine whether you are a stock, with earnings that can fluctuate wildly with the market, or a bond, with earnings that are less flashy but steady.
You will likely find that the overall level of risk you are taking is much higher or lower than you think.
Your Personal Beta
So, how do you go about finding out whether you're a stock or a bond? ALISON SEIFFER
The first step is simply understanding that a large part of your assets isn't the obvious stuff—the stocks and bonds you own, your house, your collection of fine art, your pension benefits. It's your human capital. It's you. It's a measure of your future earnings, a product of what you've invested in yourself. Think of your monthly paycheck as the dividends on your human capital. The younger you are, the larger the percentage of your assets that's made up of your human capital. In fact, if you are a recent college graduate, your human capital amounts to millions of dollars and probably makes up some 90% to 95% of the value of your total assets.
If a stock has a beta of 1, it means that it's likely to move pretty much in tandem with the overall market. A beta above that means that if the market falls, the stock will likely fall by even more; a beta below 1 means the stock won't move as much as the market.
Similarly, if you have a personal beta of 2, it means that if the market goes down 25%, your paycheck plummets 50%. If you think that a 25% drop will have absolutely no impact at all on your livelihood—although I doubt it—then your personal beta is zero. If you want to get a back-of-the-envelope measure of your personal beta, ask yourself how the past few years have affected your paycheck.
So, for example, I'm pretty certain the personal beta of Supreme Court justices is zero. Regardless of what happens to the market, they are getting their steady paycheck. Likewise, our local snowplow driver has to contend with the risk of a nice balmy January, but has a beta close to zero. It isn't that his income doesn't fluctuate. But that volatility has little to do with the stock market.
This is more than just an academic exercise. Coming to grips with your personal beta is essential for knowing the true amount of risk you are taking, as well as for building a properly diversified investment portfolio. Ignore your beta at your own peril.
The Proper Level of Risk
Once you know your beta, the next step is to figure out how to make sure you have the right risk in your investments, given your personal balance sheet. Here are three ways to do that:![[RISKJUMP]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_uo23jDNemW4_sGOPC7ZWwvyyUjoTOakgDjleyqfoNPuaEHd8yVT9uVQRrRU-SPvvNeDAapslpuP5-or7Y0S2cfB3NtROIGrPcNsX7mtGzurYRzeUZkzzZVOpcRrTUr-TBshNiyCoZ3xRNcNPe8BacKvA=s0-d)
ALISON SEIFFER
A Question of Balance. This is the most-basic strategy, and yet the one that few people actually follow. I'll put it as plainly as possible: If you have a high personal beta, if the returns on your human capital tend to fluctuate with the market, then your financial capital—your 401(k), IRA, brokerage account, etc.—should be invested more conservatively. It doesn't matter if you feel the market is due to rise, it matters less if you think you can emotionally stand the ups and down of stocks. You should instead be considering that if markets decline over a prolonged period of time, there is a greater chance you might lose your job, be unemployed for a long time, own worthless stock options and so on.
So, to all you high-beta people out there, I say now might be a good time to take some money off the market's table, even if you are bullish. Remember that your human capital—with your monthly paychecks being the dividend on this capital—is already "in the market." You probably can't afford to be all in.
In fact, I'll go so far as to say that if your beta is unmistakably above one, you probably should have little to nothing invested in stocks during the first decade or two of your working life. You belong in bonds. Then, paradoxically and contrary to conventional wisdom, as you get older and have effectively converted some risky human capital into safer financial capital, you can finally afford to allocate nest-egg funds to riskier stocks.
At the opposite extreme is the Supreme Court justice, or perhaps the tenured university professor (like myself). I may not be paid as much as the M.B.A. students we're minting, but the sensitivity of my earnings to the market is almost zero. Therefore, I can afford to take on more risk with my financial capital. In fact, if you have to know, I am 100% invested in equities. Yes, all the way. This is not because I am bullish, (I have no clue, nor do I really care), but rather because my personal balance sheet can handle the risk. My personal beta is zero.
I am a bond.
Rethink Your Insurance. Human capital isn't influenced only by the stock market. It is vulnerable to plenty of other factors. I am talking about death, disability and extended illness.
Life and disability insurance isn't only about replacing this year's lost income, it's about restoring your entire life's human-capital value. So, if you manage to increase your human-capital value, whether through more education, unique experience or a promotion, then get additional coverage regardless of whether there was an immediate change to your monthly income. Likewise, if your human-capital value becomes safer (for example, being granted tenure), you should increase your coverage.
In other words, insurance shouldn't be treated as some piece of paper sitting in a long-neglected drawer. Instead, view insurance as part of your total asset allocation, something to be revised and rebalanced just like your financial-asset allocations.
To use another financial term, these policies help hedge the non-market-related uncertainty and fluctuations in your human capital's value. If your human capital crashes to zero (you are hit by a car, have a heart attack—pick your poison), your life-insurance policy will pay the beneficiary millions of dollars in death benefits. On the other hand, if your life insurance did not pay any death benefits to your family this year, chances are your human capital is still quite valuable.
The bottom line: One way to reduce the risk level on your balance sheet is to make sure you are properly insured. Insurance allows your family to treat your human capital as a little bit more bond-like—and perhaps take more risk in the family's financial portfolio.
Moreover, the more stable the value of your human capital, the more insurance you should have to protect it. Perversely, and all else being equal, people with higher betas don't need as much insurance as people with lower betas. This is because the economic value of their human capital is lower, and there is less value to protect.
Currently, at the age of 43, I own a few million dollars of life insurance.In financial terms, I am long mortality to the tune of a few million dollars. Once I get closer to retirement—and my human-capital value declines—I plan to reduce my long position.
Start Early. On a fundamental level there are steps we can all adopt to reduce the risk level on our personal balance sheets, but these actions must start when we're in college, and perhaps even earlier.
Recall that the dividends you receive from your human capital are not solely the result of hard work, innate skills, fortuitous parents or sheer luck. Rather, these dividends can be traced to the investment of time, money and effort during your student years. The skills you acquire in your late teens and early 20s set the stage for the value of human capital. Surgeons who spent more than 10 years as undergraduates plus medical school and then internship and residency invested in their human capital. They were not consuming time. They were investing time.
Therefore, in my opinion—and this might get me in trouble with my academic colleagues—too many students (and some parents) view education as a consumption good. They immerse themselves in a liberal-arts degree and study dance or literature or dance literature, without any regard for how this might influence the future dividends of their human capital.
It is time to wake up and measure the internal rates of return from your undergraduate major. If it is too late for you, then make sure your kids are aware of this. Invest time acquiring skills that will diversify the risk inherent in human capital. Just as consumers continue to demand greater transparency and disclosure of the risks inherent in financial products, perhaps it is time to think about the risks of an undergraduate degree in Latin or Greek. Trust me here. Learning some cost accounting, microeconomics and business statistics will help reduce the future risk on their future balance sheet. Do not let your kids leave college without a hedge for the human capital.
***
Eventually some clever teenager will develop an iPod app in which users specify background demographic information about themselves, where they live, educational achievements, job history, etc. They will then receive daily updates on the value of their entire personal balance sheet, including their human-capital value and personal beta.At first this mark-to-market value of You Inc. will be crude, blunt and controversial. But over time—and by tapping into the vast array of data from the clouds—this valuation will be refined to the same level of accuracy as any closing price on a mutual fund.
For some consumers, these daily numbers will be an immediate source of comfort since the cyclical zigs of their traditional financial capital will be offset by the countercyclical zags on the rest of the personal balance sheet. For others, such holistic accounting will only exacerbate the volatility experienced by their financial portfolio, which will ideally lead them to adjust their asset allocation.
One thing, though, is certain: Knowing your personal beta will help you manage your total risk more effectively. And that is always a safe strategy.
Dr. Milevsky is a professor at the Schulich School of Business and the graduate department of mathematics and statistics at York University in Toronto. He can be reached at reports@wsj.com.
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