The age factor in the overall composition of an investor’s portfolio is a key tenet in the overall life-cycle financial management process. This means that objectives, including retirement objectives remain the centrepiece for the financial allocation of an individual’s wealth position. Keeping tabs with the potential risks an individual faces throughout the life cycle makes the role of a wealth manager central to prepare for any unforeseen risks, as well as, aligning the financial capital towards the overall investor’s objectives.
Wealth management planning, therefore, provides for a framework that encapsulates the allocation that mostly represents the client’s needs, long term objectives as well as constraints. Considerations relating to the overall economic capital position has a role to play in order to cater for the appropriate financial allocation.
Introducing human capital that compliments financial capital
The overall economic picture of an investor is pivotal to capture the appropriate financial allocation. The mix between human capital and financial capital varies along the lifetime of an investor.
Specifically, financial capital refers to the financial and non-financial assets owned by an investor. Human capital, on the other hand, accounts for the present value of future expected income which will be earned by the investor. Future earnings for investors tend to be relatively stable mimicking the characteristics of a bond.
Cash flows accruing from future earnings could play a central role in meeting future capital requirements by the investor. In encompassing both financial and human capital the concept of an economic investor balance sheet could be introduced.
This is similar to the traditional accounting balance sheet, however, it includes human capital on the asset side, which is part of the investor’s equity.
Why consider the economic investor balance sheet for investment purposes?
Human capital is directly linked to the investor’s stage of life. Naturally, for a young investor, the present value of future earnings is significantly larger than when the investor gets older.
This should be taken into account for the overall asset allocation. Assuming that the investor has stability in the earnings stream of income and has a long term investing horizon (thus, young adult), the asset allocation will be tilted towards growth assets. The case for their inclusion is two-fold, that is, the sizeable stable income stream of future earnings will buffer any possible short to medium term downside from growth assets, whilst the longer term investment horizon will ensure that the investor gets to ‘grow’ assets over time and mitigate against any interim market dips.
On the other hand, as the investor grows older, the gradual de-risking (over time) in the overall financial asset allocation will take place in order to account for the smaller size of future expected income and the shorter investment horizon. The de-risking asset allocation means that the investor will be exposed to less growth-oriented assets and more stable financial assets.
A properly planned wealth framework will include the above amongst other determinants. This will ensure that the investor’s asset allocation will be resilient and efficient to meet longer term financial objectives.
This article was issued by Jesmar Halliday, Discretionary Portfolio Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.