Thoughts about capital allocation
In a previous article (Things to consider when investing), it was mentioned that the factors that will determine whether capital is allocated to risky assets are the investment objective, time horizon, return objective and your willingness to take risk. The question that comes to mind is what is considered to be capital?
From a financial planning perspective all forms of capital should be included. Although this seems obvious, many investors often ignore the capital locked into their residences and totally ignore human capital. Doing so often leads to the misallocation of capital.
For many investors, the value of their residences is their single largest investment.
At some point in time this investment will be liquidated, e.g. when the kids move out and the excess space and high upkeep is no longer required. Downsizing could result in capital becoming available which can be used for retirement funding. The fact of the matter is that viewing your residence as part of your investment portfolio’s allocation to the property sector will and should restrict your allocation of investable funds to this sector.
As previously mentioned human capital (HC) is often ignored in determining investable capital. But should human capital be excluded?
HC is the discounted value of an individual’s future earnings. When individuals leave school or varsity many of them start off with negative equity, i.e. no tangible assets and a student loan. Can we ignore the fact that a 20 year investment was made towards their education? The answer is an obvious “no”. The return on this “investment” is what is known as human capital. It’ value is the discounted value of the individual’s expected future earnings.
As with any other investment, the return profile of HC will differ from individual to individual. Some professions provide for a rising stream of regular income e.g. teachers and accountants. For others it could be closely connected to the state of the economy e.g. asset managers, property developers and building contractors.
When considering different investment options, one should be cognisant of the nature of your human capital.
If it is derived from a certain and regular income stream it could be considered to be “bond-like”. A higher allocation to “equity-like” investments should be considered. If however your HC is derived from an uncertain or volitile future income stream, i.e. it is considered to be “equity-like”, larger emphasis should be placed an “bond-like” or safer investment options.
Source: Jac van der Spuy, PSG Konsult Tyger Waterfront