Preface to the Second (Revised) Edition of Are You a Stock or a Bond?: Identify Your Own Human Capital for a Secure Financial Future
In the revised edition of this book, I have updated and revised many tables, charts, and graphs that appeared in the original to better reflect an economic reality that has emerged after the financial crisis of 2008/2009. However, I tried as best as I could to leave the narrative structure of the book as close as possible to the original. Alas, exercising much self-control, I resisted the urge to rewrite the entire manuscript to better reflect my current thinking on the proper way to calibrate financial capital with human capital. That said, even with the passage of time—and in today’s riskier and more uncertain environment—I believe that the main message of the original Are You a Stock or Bond? remains exactly the same. Namely, you must be cognizant of the value, return, and risk classification of your human capital, which is your job, career, and what you do for a living. Human capital is likely the most valuable asset that you own over your lifecycle. Therefore, you should make certain to balance any-and-all “allocation” decisions regarding financial capital, with the economic characteristics of your human capital. Strategic financial planning must be done holistically. Moreover, the key retirement trends that I identified in the first edition of the book, penned in the relative calm of 2006 and 2007, namely, the decline of defined benefit (DB) pension provision, the continued increase in human longevity, and the risk of personal inflation, are as relevant today as they were five years ago. If anything, the financial crisis has taught us all that money is fragile, debt must be carefully monitored, and diversification across all types of capital—human, financial, and social—are key to a stable and secure financial future. You are still wealthier than you think.
How Much Risk Are You Really Handling?
I normally don’t speak to anybody on airplanes unless it is absolutely necessary, preferring instead to mind my own business, catch up on emails, or fill in paperwork. However, when the attractive, middle-aged lady sitting next to me on the flight from Dallas to Boston asked me whether the article I was reading was interesting, I decided to break my long-standing aviation rule and take up the conversation.
Apparently, Kimberly—or Kim as she preferred to be called—was flying to a job interview at a large and well-known financial services company headquartered on the east coast. She was rather apprehensive about the interview because the advertised area was completely new to her, and she didn’t have much experience or knowledge of the financial industry. Being a professor of finance myself, offering some tips and trends was fun and easy for me.
As we chatted, it became apparent that she had recently lost her job at a medium-sized manufacturing company around the Dallas area—a casualty of cheaper labor and products from overseas—and was instead trying her luck in a completely different field. Her extensive expertise and knowledge of a particular software program used by her previous employer was of little use outside of the narrow manufacturing sector in which she had spent the last decade of her life. So, she was basically starting from scratch.
To make matters worse for Kim, although she was employed at the Dallas-based company for more than eight years, she didn’t have much savings accumulated in her employer-sponsored, tax-sheltered savings plan. The company didn’t offer a traditional pension plan, which actually had been frozen years ago. Indeed, the bulk of her tax-sheltered (also known as 401(k)) savings plan had been allocated to one mutual fund and the common stock of the company she actually worked for. Neither of these investments had done very well in the last few years, and her account value was well under the cost basis of the funds. Basically, it was worth much less than the sum of all the money she had ever invested in the plan. The reason she had allocated so much to this one stock is because the company offered a matching deal. Every $100 of salary she deferred and contributed to the 401(k) plan would be matched by the company with $50 of company stock. Effectively, she was getting a 50% investment return on her money, from day one—and it was tax deferred. At first glance, this is a great deal, and many companies offer the same plan. Unfortunately, though, her company’s stock price had fallen by more than 60% in the last 18 months, which basically wiped out the gains. In fact, the day she and more than 1,000 other employees were let go, the stock price fell a further 15%, likely because the company announced a major restructuring at the same time.
I obviously felt bad for her, although she seemed to be dealing with her financial misfortune with great poise. She was actually looking forward to starting a new job and perhaps new life working in the financial services industry in Boston. She said it reminded her of graduating from college almost 15 years ago with no savings, no relevant work experience, and a bunch of credit card debt. What a great, positive attitude.
As the flight continued and the conversation evolved, it turns out that she was recently separated from her husband, who coincidently had also been laid off from the same employer on the exact same day. Kim had originally met him at a company picnic a number of years ago, and they had much in common, including a shared employer and career prospects. But, the stress of the dual job loss and the ensuing financial strain had taken a toll on their marriage, and the two of them were in the process of selling their house, which was located a short commute from their old employer, while working out the divorce proceedings.
As if the stress of a job loss wasn’t enough, unfortunately, the real estate market wasn’t being kind to them either. The house was apparently now worth 20% less than what they had paid a few years ago, and they were having a very tough time getting any offers on the house. I suspected that this difficulty is likely because a number of other residents in the neighborhood, who had also been laid off recently, were also trying to sell their homes at the same time.
Kim was hoping that they would eventually be able to sell the house for at least the value of the mortgage, which, of course, is the amount they actually owed the bank. Otherwise, they might be faced with the terrible possibility of having to file for bankruptcy, or perhaps even face foreclosure. Apparently, Kim and her husband had financed the purchase of their house with an adjustable rate mortgage (ARM) whose underlying interest rate had just been reset to a higher level. The monthly payments were now double what they were two years ago.
As you might suspect by this point in the narrative, I never actually met a Kimberly on an airplane to Boston. I’m sure many Kimberlys are out there; I just haven’t met them yet. I made up her and her very gloomy life just to make a point. Many nice people who have successful jobs, lovely houses, and hefty 401(k) accounts are destined to be Kimberly. They just don’t know it yet.
These individuals have placed too many of their life eggs in one basket. They have, unfortunately, allocated their careers, houses, investment portfolios, and even marriages into one economic sector. They have thus violated the most important rule of modern financial theory, and that is to diversify your risk factors. Many people incorrectly believe that diversification only applies and is relevant to the stocks and bonds in your investment accounts. The truth is that it should be applied to anything that has the potential to generate an income or cash flow. Diversification should be applied to all the stocks and bonds in your daily life, not just to your financial portfolio.
In today’s volatile economic environment and financial markets, investors are constantly reevaluating their attitude to financial risk on virtually a daily basis. During the times and periods stock markets are in positive territory and increasing in value, the masses believe they are risk tolerant. Then, in the next week, month, or year when markets decline sharply, they decide they are risk averse and can’t handle the volatility. They sell out, liquidate, and mistime the market. Their attitude to financial risk is more fickle than the markets themselves, and risk-aversion becomes an elusive temperament without a solid foundation. It is, therefore, almost meaningless to ask people what their risk attitude is. It changes based on yesterday’s market, today’s mood, and even tomorrow’s weather. How can one make investment decisions regarding hundreds of thousands of dollars based on the answer to a question that changes daily?
This book argues that your approach to financial risk should not be based on a psychological mindset based on your temper du jour, but instead on the composition of your entire personal balance sheet. My main message is that YOU must start approaching your financial situation in a more holistic manner. Your house, city, job, marriage, and even health is a financial asset that must coexist and be diversified with the rest of the financial assets and liabilities on your personal balance sheet. In this book, I explain why this holistic diversification is so important and how you can do it.
In the past, a financial portfolio of stocks and bonds was more of a perk than a necessity. The investment account was a retirement income supplement or perhaps a part-time hobby. Today, your stocks and bonds—very broadly defined—will become the means by which you will be able to finance and support the last 20 or 30 years of your life. You owe it to yourself to base these decisions on more than “do you feel lucky today?”