No Portfolio Is an Island

David M. Blanchett and Philip U. Straehl

Financial Analysts Journal, 2015, vol. 71, issue 3, 15-33

Abstract: The authors incorporated nonfinancial assets—industry-specific human capital, region-specific housing wealth, and pensions—into a traditional portfolio optimization and found that the optimal portfolio varies materially for different compositions of total wealth. In particular, they found that the optimal equity allocation decreases with age, riskier employment, and riskier homeownership, whereas it increases with guaranteed pension income. These results suggest that every portfolio needs to be considered in the context of an investor’s total wealth.Such assets as human capital, real estate, and pensions often represent a significant portion of an investor’s total wealth, even though stocks, bonds, and similar financial assets get more attention. Investors ignore these nonfinancial assets when building portfolios, despite the risks they share with financial assets. In our study, we explored the impact of incorporating these nonfinancial assets into the optimal portfolio by using a single-period optimization routine. We found that across 1,000 total wealth compositions considered, incorporating nonfinancial wealth results in an average increase in risk-adjusted return of 30 bps.We provide evidence that the optimal asset allocation varies materially for different compositions of total wealth. Specifically, the optimal equity allocation decreases gradually from 61% at age 25 to 26% at age 65 as a person’s human capital erodes and housing wealth and financial wealth rise. We demonstrate that the optimal portfolio varies significantly for various industry-specific types of human capital. For instance, the optimal equity allocation is higher for a person with less volatile human capital, and vice versa. Similarly, we found that human capital is correlated with the value factor and that region-specific housing wealth also affects the optimal equity weight.Our findings suggest that investment portfolio efficiency must be gauged with respect to its risk contribution to an investor’s total wealth as opposed to financial wealth alone. Therefore, when developing portfolios for clients, private wealth managers should consider clients’ holistic wealth and not focus exclusively on their financial assets.Editor’s note: The authors may have a commercial interest in the topics discussed in this article.

Date: 2015
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DOI: 10.2469/faj.v71.n3.5

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