Building a truly efficient portfolio involves a lot more than a plotted dot on a risk-return graph, said David Blanchett, a managing director and head of retirement research at PGIM DC Solutions.

Advisors need to look at a client’s total wealth, the goal, the need for income at a later date, taxes, time and the possibility of client regret. Only then can that client’s personalized efficient portfolio be determined, he said.

“There’s nothing fancy here. It’s not overly technical,” he said during a presentation at this month’s Investments & Wealth Forum in New York. “The takeaways are how some of these concepts matter and how some of the frameworks that you might typically use might be wrong for someone based upon all these factors.”

The name of the presentation, “No Portfolio Is An Island,” referenced the 17th century poet John Donne’s line, “No man is an island.”

“Portfolios don’t exist in isolation. Everyone saves money for a reason, and it’s that reason and everything else that affects how you should invest it,” Blanchett said, adding that advisors often define “good” and “bad” portfolios by where they sit on the efficient frontier between risk and return.

“This is very myopic. It’s focused on what are the returns for the asset classes, what are the standard deviations and the correlations. That ignores everything else,” he said. “Diversification is not just combining large-cap and bonds, or large-cap and small-cap. It’s thinking about large cap, my human capital and my business. It’s everything that’s investible and uninvestible that matters, that creates this idea of diversification for clients.”

For example, when thinking about the total wealth of a client, too many advisors make the mistake of thinking there’s an accumulation phase that leads up to retirement, and then a drawdown phase where those accumulated assets are spent, he said. Here is where financial capital is the focus— the 401(k), the IRA, the taxable account, all of the investible wealth.

The problem with that, he said, is that this isn’t everything. There’s also human capital, which Blanchett defined as the mortality-weighted, net present value of future earnings; housing wealth, which has its own risk because a client could rent and invest the difference; and pension wealth, which includes Social Security, the largest asset for many Americans.

“The perfect example of why human capital matters is Enron. At Enron, at one point in time, more than 90% of the 401(k) was invested in Enron stock. The problem for individuals when it comes to combining their human capital and their financial capital is when things go wrong, it’s bad for everything. They lost their 401(k) and they lost their job. The question then is, ‘How risky is human capital?’”

For a client who works in financial services, for example, an advisor might reduce equities investments in financial services because the client is already exposed to that risk through their human capital.

Referencing Moshe Milevsky’s book “Are You A Stock Or A Bond?,” Blanchett suggested advisors ask that question of everything a client owns, and the answers to that will determine how to invest the remainder of their assets, primarily their financial capital.

Human capital, for example, is relatively bond-like, he said, in that it provides a relatively consistent stream of income. But there can be shocks. A tenured professor’s income stream is safer than a realtor’s.

And some of the cornerstones of wealth, like home ownership, are much riskier than one might think.

“Looking at the rolling 20-year real return of stocks, bonds, bills and housing, housing’s return is pretty low, and its risk level falls between bills and bonds,” he said. “This would imply that the rolling risk of homes is a lot more bond-like than stock like. But here’s the problem with that analysis. If you own only one home, you have significant idiosyncratic risk.”

Home price indices contain diversification, he pointed out, but the individual homeowner with a single house does not have that.

“When you start to strip away this idea of diversification across regions, what happens is the risk of homes increases dramatically. Historically, it’s like a 50/50 stock-bond split, based on historical annualized volatility,” he said.

This is important because most people who buy homes buy them with leverage in the form of a mortgage.

“If the equity portion of a home is 50/50 stocks and bonds, and you buy a home with 20% down, what you now effectively have is a 2.0 leveraged exposure,” he said. “So homes are actually quite risky.”

For clients who put down just 10% of the purchase price, the home is leveraged at debt-to-equity exposure of 4.5, which is very high. Clients should still buy them for having a place to live, good school districts, lifestyle and the like, he said, but they should be aware they’re not incredibly safe assets without the passage of time and the increase in equity.

When analyzing pension wealth, social security is often a client’s biggest pension asset and the safety of guaranteed, inflation-protected income is not to be underestimated, Blanchett said.

“I’m a fan of individuals allocating more to income that is protected for life. The best place to get it is a delayed claim to social security, but for a lot of folks that’s not going to be enough. I know saying the A-word, annuity, can get people up in arms but just bear with me here.”

In a scenario where an advisor has a client who wants more income that’s guaranteed for life, Blanchett assumed a starting portfolio that was 45% stocks and 55% bonds. If the client buys a single-premium immediate annuity (SPIA) with 25% of the portfolio, the income from the annuity is very bond-like, and the advisor could allocate the purchase entirely from the bond assets.

The portfolio is now 25% SPIA, 30% bonds and 45% stocks.

“That would make your portfolio more aggressive. You would go from being 45% stocks to effectively 60% stocks versus the bonds,” he said. “What you would maintain, though, is the same level of overall risk for your client.”

To get a bird’s-eye view of a client portfolio, Blanchett recommended advisors use a balance sheet that’s more sensitive to a variety of client assets, one that goes beyond basic categories of assets and liabilities.

For example, Blanchett uses a balance sheet that breaks assets into financial capital (liquid assets, investments and personal property), human capital and pension value. On the liabilities side are debts (credit cards, car loan, home mortgage and home equity loans), the present value of lifetime consumption needs, and bequests. Put the two together for net wealth.

“Then you ask the question, ‘Are you ahead, or are you behind?’” he said.

Of all the assets groups, the non-tradeable assets are human capital, housing wealth and pension wealth, he said. Financial capital, however, is tradeable.

“You utilize financial capital as the lever that you move up and down based upon the other stuff. If your client has a business, and that’s where a lot of their wealth is, that would be a very risky asset. It would suggest that their capacity for risk in other areas of their portfolio is lower,” he explained. “So you would start at a lower place in terms of how you would invest that. You could still invest aggressively based upon their risk tolerance, but the key here is thinking about these other structural components and then backing into the risk of their financial wealth.”