An Asset Allocation Based On Your Job

While mean-variance optimization was built primarily for available investments in a portfolio, there’s no reason it can’t be applied more broadly across both financial and human capital. In fact, given how human capital in different industries has different risk-return characteristics and thus different correlations to asset classes, it’s possible to determine what the optimal allocation should be even when diversifying across the financial and human capital.

Once the risks and volatility of human capital are considered, the “optimal” portfolio looks remarkably different. REITs, for instance, are already sensitive to both interest rates and the economic cycle, so they do not appear to add any unique diversification to a worker’s existing human capital. Also, because most businesses today are global in nature, diversification into non-U.S. equities shows almost no value in the human-capital-diversified portfolio. 

On the other hand, small-cap value is an especially appealing diversifier. Why? There are more people working for large companies than small (as captured by Blanchett and Straehl’s use of cap-weighted industry indexes), which implies that most human capital already favors large cap … so small-cap value is a good diversifier. Of course, a worker already employed by a smaller capitalization company might not find owning more small-cap stocks to be as valuable, so his or her portfolio would tilt back toward more large caps instead.

In some cases, the optimal exposure and relevance of a particular asset class is very sensitive to the particular industry. For instance, high-yield bonds are most relevant as a diversifier for those working in financial services or the transportation industries, but not for government workers or those in mining or utilities. Long-term government bonds (and also international bonds) are especially good diversifiers for the construction, lodging, mining and real estate industries, but quite poor for government, health-care, manufacturing and utilities workers.

Overall, the study finds that the average allocations of a human-capital-adjusted portfolio change by 37.6%. The change is more than 50% for the most “extreme” industries: government, manufacturing and utilities (i.e., those with the most materially different risk/return and correlation characteristics).

Allocating Exposure Around Jobs

Taking these factors into account, portfolios can also be designed not only around asset classes but around specific sectors and how they relate to a worker’s existing job exposure. For instance, it probably isn’t very helpful for someone working in utilities to own utilities stocks. But those companies could be a very good diversifier for someone working in the construction industry.

The best portfolios can vary significantly, with manufacturing, utilities, government and health care showing the most significant differences from job-agnostic portfolio designs.

Notably, the results suggest that certain industries have no useful portfolio diversification value at all. The optimal allocation to the financial services industry, to durable goods and to manufacturing is 0% across the board for workers in all industries. It’s zero for business equipment as well. (But these were also zero when the workers’ industries were ignored, suggesting these sectors aren’t helpful in the first place from a portfolio optimization perspective.)

Will Future Portfolios Be Job-Specific?

While some might quibble with the particular selection of industries and data used in the Morningstar paper, the fundamental point remains that for workers still in the accumulation phase with years until retirement, human capital really does have significant value, significant risk and a significant relationship to the risk/return characteristics of other assets in a portfolio. This represents an opportunity to diversify against those risks.

So how might this approach look in practice? A starting point would be to reduce a client’s U.S. exposure to the industry he or she already works in (less in utilities for a utilities worker, less in REITs for someone who works in real estate, etc.). It also means adjusting cap-weight exposures (adding more to small-cap positions for someone who works at a large-cap company and
vice versa). 

Diversifying As A Financial Advisor

Notably, this job-based approach is as relevant for financial advisors as our clients. Our jobs are especially exposed to, and correlated with, the economy and the stock market. When a recession occurs and a bear market emerges, it’s a hit to everything from our job prospects to our profits. And of course, if you are an advisory firm owner, the situation is even more extreme, as the value of your firm—based on a multiple of profits or free cash flow—is not only correlated to the markets but even more volatile.

This implies that advisors should be especially conservative with their own portfolios and even, ironically, dial down their equity exposure (especially to the financial services sector). Similarly, they should maintain larger cash allocations or emergency reserves, and more aggressively pay down any personal debt.