Me, Mick Jagger and investing risk

By Roger Ibbotson

Mick Jagger and I are the same age, but we probably don't have the same asset allocation -- the same mix of stocks, bonds and cash -- in our portfolios. That's because age doesn't (or at least shouldn't) single-handedly dictate an investor's stock-bond blend. Instead, it's a matter of an investor's current savings (financial capital) versus his future potential savings (human capital) that should set the mix.

More on me and Mick later.

On average, the asset allocation decision is the most important choice an individual investor will make -- particularly for an investor who invests primarily in mutual funds. Sure, some mutual-fund managers beat their benchmarks consistently, but on average (especially after factoring in fees) they don't. So for most investors, the amount he or she has decided to dedicate to stocks versus bonds is going to drive returns more than which mutual funds are picked and when they are bought or sold.

But determining the proper mix has never been an exact science. One rule of thumb is to subtract your age from 100 -- the result is the percent that you should allocate to stocks. So a 40-year-old investor would have 60% of his portfolio in stocks, while a 75-year-old would be 25% in stocks.

The problem with this equation (and most other purely age-based guidance) is that investors end up with portfolios that are too conservative, and they run the risk of falling short of their long-term financial goals.

Human junk bonds

A better way to approach asset allocation is to think of your wealth more holistically -- as both the money you currently have in your portfolio dedicated to retirement, which we call financial capital, and all the potential money you will save over your lifetime for retirement, which we call human capital. The goal is balance -- you want your financial capital and human capital to balance each other out.

Your human capital is very bond-like. You can reasonably expect to receive regular, pre-defined payments in the form of a paycheck throughout your years in the workforce, much like interest payments from a bond. In the most simple example, a young person has a great deal of human capital, since he or she has many years left to work and save, but usually very little financial capital. To balance out this large portfolio of bond-like human capital, the young investor should invest his or her financial capital very aggressively in stocks. This also makes sense intuitively -- a younger investor can afford to take on more risk than an older investor because he or she has a long time horizon to ride out a severe market downturn.

But there's more to determining human capital than just years in the workforce. As we've mentioned, a person's human capital is very bond-like. But it's more like a junk bond than a government bond or even a high-grade corporate bond -- and some people's human capital is "junkier" than others.

The risk profile of an individual's human capital depends on job stability, savings rate, income stability and physical health. Changing jobs, dropping out of the workforce, falling ill, etc., all impact the amount of risk in your human-capital portfolio. So, for example, someone who works on commission, or in the type of job that is being outsourced, has a more risky human-capital profile than someone who may work for the government and is entitled to a pension. All of these people may be the same age, but the commissioned stock broker should have a more conservative portfolio than the government mail carrier, all else being equal.

Exile on Wall Street

In the case of Mick and myself, Mick's prolific and seemingly endless rock career affords him much more human capital than I have at this point in my life. His royalties also add a significant bond-like component to his financial capital that can't be diversified. Since a significant portion of his financial capital comes in the form of regular dividend payments (royalties) and he still has substantial future earnings potential with touring and recording, Mick's asset allocation should be more aggressive than mine.

Here are few asset allocation rules-of-thumb using the human capital framework:

Aggressive

• Younger investors have more bond-like human capital and should therefore invest more of their savings in stocks than older investors who have significantly more financial capital.

• Investors with a secure income stream (human capital that's like a high-grade bond) can invest more of their financial portfolio in stocks.

• People who are savers versus spenders have greater human capital and can also invest more aggressively.

Conservative

• Individuals whose income stream (human capital) is highly correlated with the stock market, like financial planners or portfolio managers, should consider more conservative financial investments to diversify their total wealth portfolio.

• Workers whose skills are highly specialized, and can't easily change careers should their fields become obsolete, may also want to invest more in bonds.

• Investors who think they might leave the workforce due to illness or by choice should consider investing more conservatively.

So, when setting your asset allocation, don't just rely on your age to determine the mix. Start by evaluating both the amount of money you expect to save for retirement over your lifetime and the factors that can derail your plans. Then develop an asset allocation for your financial wealth that balances your human capital profile.

Roger Ibbotson is founder of Ibbotson Associates, a Morningstar company, and a professor of finance at the Yale School of Management.