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Ebook Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance

We can generally categorize a person’s life into three financial stages. The first stage is the growing up and getting educated stage. The second stage is the working part of a person’s life, and the final stage is retirement. This monograph focuses on the working and the retirement stages of a person’s life because these are the two stages when an individual is part of the economy and an investor.

Even though this monograph is not really about the growing up and getting educated stage, this is a critical stage for everyone. The education and skills that we build over this first stage of our lives not only determine who we are but also provide us with a capacity to earn income or wages for the remainder of our lives. This earning power we call “human capital,” and we define it as the present value of the anticipated earnings over one’s remaining lifetime. The evidence is strong that the amount of education one receives is highly correlated with the present value of earning power. Education can be thought of as an investment in human capital.

One focus of this monograph is on how human capital interacts with financial capital. Understanding this interaction helps us to create, manage, protect, bequest, and especially, appropriately consume our financial resources over our lifetimes. In particular, we propose ways to optimally manage our stock, bond, and so on, asset allocations with various types of insurance products. Along the way, we provide models that potentially enable individuals to customize their financial decision making to their own special circumstances.

On the one hand, as we enter the earning stage of our lives, our human capital is often at its highest point. On the other hand, our financial wealth is usually at a low point. This is the time when we began to convert our human capital into financial capital by earning wages and saving some of these wages. Thus, we call this stage of our lives the “accumulation stage.” As our lives progress, we gradually use up the earning power of our human capital, but ideally, we are continually saving some of these earnings and investing them in the financial markets. As our savings continue and we earn returns on our financial investments, our financial capital grows and becomes the dominant part of our total wealth.

As we enter the retirement stage of our lives, our human capital may be almost depleted. It may not be totally gone because we still may have Social Security and defined-benefit pension plans that provide yearly income for the rest of our lives, but our wage-earning power is now very small and does not usually represent the major part of our wealth. Most of us will have little human capital as we enter retirement but substantial financial capital. Over the course of our retirement, we will primarily consume from this financial capital, often bequeathing the remainder to our heirs.

Thus, our total wealth is made up of two parts: our human capital and our financial capital. Recognizing this simple dichotomy dramatically broadens how we analyze financial activities. We desire to create a diversified overall portfolio at the appropriate level of risk. Because human capital is usually relatively low risk (compared with common stocks), we generally want to have a substantial amount of equities in our financial portfolio early in our careers because financial wealth makes up so little of our total wealth (human capital plus financial capital).

Over our lifetimes, our mix of human capital and financial capital changes. In particular, financial capital becomes more dominant as we age so that the lower risk human capital represents a smaller and smaller piece of the total. As this happens, we will want to be more conservative with our financial capital because it will represent most of our wealth.

Recognizing that human capital is important means that we also want to protect it to the extent we can. Although it is not easy to protect the overall level of our earnings powers, we can financially protect against death, which is the worst-case scenario. Most of us will want to invest in life insurance, which protects us against this mortality risk. Thus, our financial portfolio during the accumulation stage of our lives will typically consist of stocks, bonds, and life insurance.

We face another kind of risk after we retire. During the retirement stage of our lives, we are usually consuming more than our income (i.e., some of our financial capital). Because we cannot perfectly predict how long our retirement will last, there is a danger that we will consume all our financial wealth. The risk of living too long (from a financial point of view) is called “longevity risk.” But there is a way to insure against longevity risk, which is to purchase annuity products that pay yearly income as long as one lives. Providing that a person or a couple has sufficient resources to purchase sufficient annuities, they can insure that they will not outlive their wealth.

This monograph is about managing our financial wealth in the context of having both human and financial capital. The portfolio that works best tends to hold stocks and bonds as well as insurance products. We are attempting to put these decisions together in a single framework. Thus, we are trying to provide a theoretical foundation—a framework—and practical solutions for developing investment advice for individual investors throughout their lives.

In this chapter, we review the traditional investment advice model for individual investors, briefly introduce three additional factors that investors need to consider when making investment decisions, and propose a framework for developing lifetime investment advice for individual investors that expands the traditional advice model to include the additional factors that we discuss in the chapter.


Chapter 1. Introduction
Chapter 2. Human Capital and Asset Allocation Advice
Chapter 3. Human Capital, Life Insurance, and Asset Allocation
Chapter 4. Retirement Portfolio and Longevity Risk
Chapter 5. Asset Allocation and Longevity Insurance
Chapter 6. When to Annuitize
Chapter 7. Summary and Implications
Appendix A. Human Capital and the Asset Allocation Model
Appendix B. Life Insurance and the Asset Allocation Model
Appendix C. Payout Annuity Variations

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