The Impact of Human Capital on Financial Asset Allocation

Expected future labor income (a flow) can be converted into human capital (an asset) by discounting it to its present value.   The present value of your human capital therefore depends on a number of different variables.  The first is your current expectation for the size of your annual future labor income flows.  All else being equal, the higher your expected future annual labor income, the higher the present value of your human capital.  The second consideration is how many remaining years of labor income you expect to receive.  All else being equal, the more remaining years of income, the higher the value of your human capital.  The third variable is the riskiness of your labor income.  This is a function not only of the different factors that directly affect it (e.g., global, national and regional/local economic conditions, conditions in your industry and company, and personal factors, such as your ability to hold your tongue in the face of clueless comments by your boss), but also of the flexibility you have to supplement it (e.g., by working a second job).  All else being equal, the less risky your labor income, the higher the value of your human capital.

To get a better understanding of how risky labor income actually is, we looked at national accounts data from the United Kingdom and the United States.  In the former, between 1971 and 2001, the average annual nominal change in compensation of employees was 9.95% per year (based on annualized quarterly data), with a standard deviation of only 3.20% per year.  The United States data covered 1971 to 2002, and was broken down into three categories: wages and salaries paid to private sector employees, wages and salaries paid to public sector employees, and proprietors' income for non-farm businesses (essentially, self-employment income).  The average annual rates of change, and associated standard deviations, are shown in the following table, along with comparable data for the returns and risk for domestic bonds and equities over the same period.

	Average Annual Change or Return	Standard Deviation
Public Sector Wages and Salaries	6.39%	1.53%
Private Sector Wages and Salaries	7.33%	2.51%
Proprietors' Income	7.98%	4.41%
Domestic Bonds	9.08%	6.98%
Domestic Equities	12.70%	17.59%

This table makes two interesting points.  First, labor income is less risky that domestic bonds or equities.  Second, within the broad category of labor income, public sector employment is the least risky, while owning one's own business is the most risky.

Now let's look at the theoretical linkage between the value of your human capital and the allocation of your financial portfolio between different asset classes. Assuming people seek to avoid big swings in their current consumption of goods and services, the higher the value of your human capital, the more risk you can afford to take in your financial portfolio (because temporary setbacks in the value of the latter will be much less likely to affect your current consumption). 

In their paper "Investing Retirement Wealth: A Lifecycle Model", Campbell, Cocco, Gomes, and Maenhout note the impact of aging on the labor income/financial asset allocation relationship: "A typical individual starts adult life with little financial wealth; initially, as labor income increases, human wealth may grow faster than financial wealth, but fairly early in adult life financial wealth starts to accumulate faster than the present value of remaining labor income.  This implies that most younger investors with relatively safe labor income should concentrate their portfolios heavily in equities, and gradually shift toward less risky investments as they approach retirement." It also implies that younger investors with relatively riskier labor income should allocate less of their investment portfolio to riskier asset classes.

These authors also add detail to the relationship between labor income risk and financial portfolio risk: "the [current] theoretical literature on [the relationship between labor income and financial asset allocation] can loosely be summarized as follows If labor income is [low risk], then [holdings of low risk financial assets] are crowded out and the household will tilt its portfolio strongly toward [higher risk] assets If labor income is risky, but uncorrelated with [the returns on] risky financial assets, then [low risk] financial asset holdings are still crowded out, but less strongly; and the portfolio tilt toward [higher risk] assets is reduced.  And if labor income is positively correlated with risky financial assets, then [higher risk] assets can be crowded out, tilting the portfolio toward [lower risk] financial assets.

A critical empirical issue is therefore the extent to which changes in labor income are correlated with returns on different asset classes.  In the past, the standard theoretical models assumed a relatively strong positive correlation between changes in labor income and changes in the rate of return on a broad equity index. This conclusion was based on the observation that many investors held relatively low percentages of their financial portfolios in higher risk asset classes such as equities.  However, recent research has found that this assumption was incorrect.

The following table shows the correlations between nominal changes in different types of labor income in the United States between 1971 and 2002 and nominal returns on different asset classes.

Asset Class	Correlation with Changes in Public Sector Wages and Salaries	Correlation with Changes in Private Sector Wages and Salaries	Correlation with Changes in Proprietors' Income
Real Return Bonds	.18	(.01)	(.06)
Domestic Bonds	(.14)	(.13)	(.26)
Foreign Bonds	(.26)	(.20)	(.12)
Domestic Equity	(.07)	.09	(.01)
Foreign Equity	(.12)	(.02)	.00
Emerging Equity	.10	.04	.09
Commodities	.10	(.02)	.18
Commercial Property	.04	(.39)	(.16)
Residential Property*	.17	.05	(.03)

* For further discussion of this asset class, see following article

The analysis presented in this table shows that changes in labor income generally have very weak correlations with the returns on different asset classes.  It also suggests that, if one were trying to hedge changes in one's labor income, one might want to consider the use of domestic or foreign bonds.  However, given that labor income appears to be much less risky than financial assets the need for this seems to be minimal.  However, this analysis is also based on aggregate level figures.  Could people in different occupations face a higher degree of labor income risk?

In their paper "Occupation Level Income Shocks and Asset Returns, authors Davis and Willen examined changes in labor income across ten different U.S. occupational groups, and found that none had a statistically significant relationship with U.S. equity market returns.  Moreover, they also note that "several [other] studies that consider a variety of countries, time periods, and income components [also] find zero or small correlations between aggregate equity returns and the value of human capital.   As a result, they conclude that "the market equity portfolio has modest value as a hedge instrument for the average investor's labor income."   However, a later study by Campbell, Cocco, Gomes and Maenhout found that the relationship between labor income and equity market returns was positive for people who are self-employed, and for college graduates (who are more likely to hold positions where compensation is partly tied to the performance of a company's stock). They concluded that "privately owned business risk is an important substitute for stock market risk." In other words, all else being equal, you would expect to find a self-employed person or someone whose compensation was tied to the performance of her company's stock holding a lower percentage of risky assets in his or her portfolio than someone with an equivalent amount of labor income from less risky sources.

Finally, Davis and Willen also found stronger correlations between changes in labor income and returns on industry level equity indexes.  This suggests two possibilities for hedging labor income risk.  You could maintain a permanent short position in the equity index for the industry in which you work, or, alternatively, one could tilt one's investment portfolio toward asset classes with returns that have historically been negatively correlated with returns on your industry's equity index.  Practically, it is very difficult for most investors to continuously maintain a short position in a stock index (either directly or via put options). Given this, we took a closer look at the second strategy.  In the following table, we show the correlation of nominal returns (we used nominal since labor income is denominated in nominal currency units) between ten different sector indexes and the equity market as a whole.  We also show the three asset classes (including other equity indexes) with the highest negative correlation with each equity index.

Sector (based on Dow Jones Sector Exchange Traded Funds)	Correlation of Returns with Overall Equity Market	Asset Classes or Sectors with Highest Negative Correlation of Returns with Sector
Basic Materials	(.17)	Energy Sector (.30); Financial Services Sector (.30) and Europe Equity Index (.16)
Consumer Cyclicals	.28	Real Return Bonds (.11); Foreign Bonds (.10); Residential Real Estate (.10)
Consumer Non-Cyclicals	.57	Real Return Bonds (.42); Domestic Bonds (.31); Residential Real Estate (.19)
Energy	.89	Real Return Bonds (.57); Domestic Bonds (.37); Foreign Bonds (.30)
Financial Services	.66	Real Return Bonds (.48); Commodities (.30); Basic Materials Sector (.30)
Healthcare	.57	Real Return Bonds (.37); Residential Real Estate (.26); Foreign Bonds (.02)
Industrials	.78	Real Return Bonds (.37); Foreign Bonds (.22); Residential Real Estate (.19)
Technology	.55	Real Return Bonds (.27); Foreign Bonds, Commodities, and Residential Real Estate, all (.10)
Telecommunications	.96	Real Return Bonds (.54); Residential Real Estate (.29); Foreign Bonds (.21)
Utilities	.86	Real Return Bonds (.44); Domestic Bonds (.32); Residential Real Estate (.30)

This table makes two points.  First, to the extent that labor income is positively correlated with the returns on an industry equity index, the equity market as a whole does not provide a good hedging vehicle.  In fact, in every case but one when the industry index (and also, we assume in this case, labor income) declines, the aggregate equity market index will likely do the same.  Second, it would seem that real return bonds, foreign bonds, residential real estate, and, to a lesser extent, other asset classes provide opportunities for hedging some amount of labor income risk in different industries. 

There are, however, two important caveats to these conclusions.

Most importantly, they are based on a relatively short data set (the broad-based Dow Jones industry sector index returns have only been available since 1992), which makes them tentative at best.  The second caveat is that the crucial link in this argument between labor income and the return on sector equity indexes is subject to some uncertainty.  For example, Davis and Willen noted that the sign of the relationship between the two (which one would normally expect to be positive) was sometimes found to be negative.  As an example of the latter, these authors cited "the introduction of labor saving technology, [which] may generate higher returns on industry equity index, but lower earnings for workers.    They concluded that "the usefulness of industry level equity portfolios as hedging instruments for [labor income] is an empirical issue which no single study can definitively settle."