What is the single biggest investment mistake almost everybody makes? If you could pick just one thing what would it be?
• lack of diversification
• holding too much (or not enough) in shares
• over (or under) exposure to emerging markets
• perhaps holding government bonds when “everyone can see it’s a bubble waiting to burst”
• maybe you think it’s selling shares after markets have fallen or buying after markets have experienced substantial gains
These are all valid suggestions but they aren’t “the big one”
The biggest investment mistake almost everyone makes is incorrectly identifying and measuring their assets; specifically failing to acknowledge certain assets at all. As asset allocation is one of the most important investment decisions we can make, we better make sure we get it right!
So, how do so many of us get it so badly wrong?
When analysing our total wealth and asset allocation most people include:
• Fixed interest securities
• Company shares
Of course, the list could be expanded to include sub assets such as shares in smaller companies but there is one glaring omission from this list – YOU
Almost no one properly accounts for their human capital as an asset in their investment plan, but for many people THEY are THEIR biggest single asset.
Take a successful professional such as a partner in a law or accountancy firm, their biggest asset may be their future earning potential, but this is rarely quantified and doesn’t appear anywhere in the asset allocation or risk budget. The value of human capital changes over time, reducing as we near retirement or increasing with promotion or a successful new business venture. The risk of this asset also varies depending on the nature of income; the future earnings of an entrepreneur will be less secure than an NHS consultant with a contract and generous final salary pension benefits. This needs to be accounted for, monitored and rebalanced in the same way as any other asset within the investment portfolio and financial plan.
Human capital is more than just earnings. Services provided to the household also provide real value that will impact the asset allocation decision. One spouse may decide not to work in order to run the home and be there to look after the kids. This non-working spouse may have no earnings but if they weren’t there there would be a real financial cost.
Many people find it challenging to conceptualise the value of human capital, let alone measure it; they just ignore it and hope the problem goes away. However, a proper financial plan with a clear lifetime cashflow analysis will provide valuable guidance. The plan can be interrogated and stress tested with multiple “what if?” scenarios to quantify the risk in relation to achieving your personal lifestyle goals.
Some scenarios are easy to imagine. If Kylie dies her income will stop and Jason will need to find some way to replace this or accept a massive change in lifestyle. Simple life assurance for an appropriate sum written in trust would provide one solution (often for minimal outlay). Most people understand this but don’t go any further.
Why am I referring to the biggest mistake being an investment allocation issue though?
You are no doubt familiar with the concept of a diversified investment portfolio. By spreading investments across non-correlated assets where some go up in value while others fall, we can reduce the overall risk of our portfolio without sacrificing too much potential return. However, we seldom include human capital in this equation.
How would your earnings be affected by a stock market crash, or property transactions slowing down further? This will depend on your career and skills. A solicitor specialising in property will be affected differently to an insolvency practitioner. How would your financial plan be affected if your earning capacity suffered at the same time as your investment portfolio tanked? It is essential to consider the full range of assets including human capital; the value of YOU.
Fortunately, the tools exist to allow for human capital in your financial planning. You should ensure you have a detailed lifetime cashflow projection and keep it up to date. At the very least this should be updated annually, or more frequently if there has been a significant change in circumstances or objectives. If it doesn’t include a cashflow analysis it isn’t a financial plan.