Aurora Borealis
1 November 2013 CFA Institute Journal Review

Human Capital and Behavioral Biases: Why Investors Don’t Diversify Enough (Digest Summary)

  1. Louis A. Lemos

The existence of human capital and its importance for investment decisions is well-known, but explicitly accounting for it is uncommon, and this failure can have devastating consequences. The failure to take human capital into account when making investment decisions can be explained by a variety of emotional and cognitive biases.

What’s Inside?

Human capital, which is the actuarial present value of earnings or wages over a lifetime, can dominate total wealth but is often ignored by individuals and wealth managers when making investment portfolio decisions. The authors suggest that behavioral biases are a key driver of the poor choices individuals make with respect to portfolio decisions related to human capital, particularly when allocating their retirement assets, which are sometimes concentrated in their own company stock. Although the major tenets of behavioral finance are well-known, the authors systematically examine them to offer explanations for why investors often fail to manage human capital risk. They also offer steps that can be taken to build portfolios that take human capital into account.

How Is This Research Useful to Practitioners?

The authors posit that recognition of the importance of human capital and clients’ biases toward it will allow wealth managers to suggest effective methods for addressing the issue. This may help avoid the potentially devastating consequences of portfolios that are concentrated in assets tied to clients’ human capital.

The authors emphasize that a large portfolio allocation to the stock of an employer, often chosen because of emotional and cognitive biases, is not prudent from a diversification standpoint because investors already have significant “life balance sheet” exposure to their employer. Hedging is one approach that could be used to ameliorate this risk, such as including assets in portfolios that are uncorrelated or negatively correlated with clients’ human capital. For example, investors who are concerned about their human capital risk can hedge some or nearly all of this risk by shorting a sector or industry exchange-traded fund (ETF) that track returns to companies in the industry in which they work. The potential for basis risk, attributable to an ETF’s tracking error and construction of the index, should be carefully considered because it will affect the efficacy of the hedge.

Thoughtful portfolio construction in the context of an investor’s undiversified human capital indicates that investors should not all hold the same standard “optimally” diversified market portfolio. Therefore, the most efficient portfolio for each investor is unique and depends on the size and character of his or her human capital. The authors conclude that wealth managers can add value as risk managers by educating their clients about human capital and constructing strategies to reduce the concentrated risk in their clients’ largest asset—their own human capital.

How Did the Authors Conduct This Research?

The authors provide a discussion of the importance of considering human capital, an explanation of why human capital is often ignored, and steps that can be taken to build portfolios that take human capital into account. The magnitude of human capital is demonstrated with an example of a “life balance sheet” that includes human capital. The authors reference several facts to emphasize the point, including, for example, that in the United States, human capital often represents 90% of total assets for investors under age 30 and nearly 50% for investors in their 50s.

The problem with a concentration in human capital is underscored by or clarify that the authors are highlighting surveys that reveal that many individual investors’ retirement plans and other financial asset holdings are disproportionately concentrated in the stock of their employer. Several examples are used (such as Enron, Bear Stearns, and Lehman Brothers Holdings) to illustrate that the concentration of investments with returns highly correlated with human capital can be disastrous for individuals.

The authors discuss a number of behavioral biases, such as overconfidence, cognitive dissonance, appeal to authority, confirmation bias, and disaster myopia, to explain the seemingly irrational behavior that individuals exhibit with respect to their own company stock when making individual portfolio decisions. They also contemplate behavioral explanations, such as prospect theory, regret aversion, and social comparison, that might not be considered biases but rather rational and conscious explanations for this phenomenon.

The authors close with a model to derive an optimal hedge ratio. They recognize that it is imperfect, but it nonetheless provides a conceptual framework that offers important insight into how much one might hedge concentrated risk in human capital.

Abstractor’s Viewpoint

Clients are retiring at older ages and saving less during their lives, which leads to human capital being an even more dominant part of their overall portfolio. As the recent financial crisis made all too clear, having a portfolio of financial assets that are highly concentrated in one’s human capital can result in significant wealth destruction. Therefore, it is imperative that wealth managers give proper consideration to their clients’ largest asset—human capital. In this regard, advisers have an obligation to construct portfolios based on the unique characteristics of each client’s human capital and adhere to the most fundamental of investment doctrines—the avoidance of single asset concentration.

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