That’s the title of a book a friend gave me recently to read.  It’s written by Moshe A. Milevsky, a finance professor at York University in Toronto.   It’s well worth reading.

insurance as a hedge

Mr. Milevsky has had a life-long fascination with insurance.  So the book has comments on the role of insurance as a hedge against loss of a family breadwinner’s income.  There’s also a section on using annuities to stabilize retirement income flows.  There’s even a brief discussion of a precursor of the annuity, the tontine–an arrangement (devised by Lorenzo Tonti) where a number of elderly people invest money jointly and meet after a specified time to split the proceeds among the survivors–as one basis of the annuity’s appeal.

There’s also the usual academic nonsense about efficient securities markets, although that’s not crucial to the book’s message.

human capital

The most important aspect of the book, to my mind, is that it points out the crucial importance of considering one’s human capital when making a personal or family investment plan.  For almost everyone, a lifetime’s earnings from working will be their largest single source of economic wealth.  Yet people tend to take a very narrow approach when planning for diversifying their financial assets and ignore their human capital completely.  As a result, they overlook two important considerations:

1.  Are you, seen as your human capital, a stock or a bond?  That is, does your income have the potential to swing significantly from year to year and is your continuing employment highly contingent on continuing strong performance?   …or are you in a job where your future income is very predictable and where you’re highly unlikely to be forced out of work?

Entertainers, salesmen or money managers are like stocks;  tenured professors are the ultimate bonds.

People with very conservative preferences may be attracted to bond-like professions, and the less risk-averse to stock-like ones.  If each treats his allocation of financial assets as a completely separate topic from his choice of a career, then both will end up with incompletely diversified economic portfolios.  The professor will end up with too much bond exposure, the investment banker too much stock.

2.  How old are you?  Milevsky’s analysis here arrives at the conventional result.  A 22-year old college graduate has an immense economic resource in the present value of his future earning power.  So he can take a lot of risk with his financial assets.  For a retiree, on the other hand, the earnings gas tank is at empty.  So his financial asset allocation must be more conservative–both relative to his own past allocations and in an absolute sense.

(Are You a Stock or a Bond?:  Create Your Own Pension Plan for a Secure Financial Future, Moshe A. Milsvsky, PhD, FT Press, New Jersey, 2009)