How much of my portfolio should be in stocks and how much in fixed income?
That’s a million dollar question that bothers most new investors.
A popular rule of thumb many financial advisors talk about is the ‘100 minus your age’ rule. It says that one should subtract his/her age from 100 and the remainder is the percentage one should have in stocks.
For instance, a 25-year old investor should have 75% (100-25) of his investments in equities and 25% in fixed income instruments.
For a 60-year-old investor, the rule dictates that he/she should have 40% in stocks and 60% in bonds and debt funds. This also means that you should rebalance your portfolio every year, i.e., as you become older you should shift 1% of your portfolio from equity to bonds every year.
Every investor is different. Different goals, different net worths, different risk appetite, and different income levels.
How can a single rule work for everyone? So this ‘100 minus your age’ rule offers only an approximation. An investor needs to know more than just his age to decide how his asset allocation should be done.
So let’s go back to basics and ask ourselves a fundamental question. Why do people invest?
Different people invest for different reasons based on their financial goals. Some invest for buying a house, some for funding a kid’s education, for marriage, or for retirement.
But the underlying theme is our expectation that in future will come a day when we might fall short of funds to cover a major expense — planned or unplanned. Investing is aimed at filling this gap.
As people save and invest, they start building another asset — a financial capital — that begins generating income. However, for most people, the primary income comes from their human capital, i.e., from their job, profession or business.
Let us understand in detail the core difference between human capital vs financial capital.
The basic definition of financial capital is something that generates cash. So both capital — financial and human — produce cash flows.
However, human capital, unlike financial capital, has a finite life. For most people, the earnings from a profession/job/business cease after a certain age.
So, the original question — how much of my portfolio should be in stocks and how much in fixed income? — is incomplete. It’s focusing only on the investment of financial capital without giving a thought to where that person’s human capital is invested.
So let me ask you this — Where is your human capital invested today? Does your human capital have the characteristics of a stock or a bond?
Stocks are generally seen as riskier than bonds because a stock’s future performance is unpredictable. A bond, on the other hand, promises a regular income (in the form of interest) and a guaranteed payout at the end of a predefined time.
Your human capital is invested in the bond if you have a stable job.
A job that is unaffected by the volatility of the stock markets. Plus you have many years left to work.
On the other hand, your human capital has the characteristics of a stock if you have relatively fewer years of work ahead of you, or if you work in a volatile and unpredictable field that can decline quickly.
For example, John is a government employee and Riya is a small business owner. Both are 50 years old and hence they have about 20 years of working years left. Do they have the same kind of human capital?
No. Being an entrepreneur, Riya’s human capital is like a stock. Whereas John’s human capital is like a bond.
This means, that when it comes to investing their financial capital, Riya and John’s asset allocation percentages will be very different. It would be riskier for Riya to allocate a higher percentage of equity in her portfolio because her human capital is already like stock.
She has to balance out by allocating a bigger chunk of her investments towards debt/bonds. However, John can afford to have a higher percentage of equity allocation in his portfolio because his job is like a bond.
Primarily two factors decide the level of risk associated with human capital. The amount of time left to earn that human capital and the nature of the job.
If Riya were a 25-year-old businesswoman, then in spite of having an unpredictable source of income, she could still afford to allocate a higher percentage for equities (as compared to the 50-year old Riya) because for the young Riya there’s a long runway ahead in terms of remaining years of productive working life.
This idea of human capital and its classification as a bond or a stock comes from the wonderful book, ‘Are You a Stock or a Bond?’ Written by Moshe A. Milevsky, a finance professor at York University in Toronto.
I hope this framework of human capital vs financial capital will help you make better investing decisions.
Disclaimer: The views expressed in this post are that of the author and not those of Groww