Prof. Giorgio Di Giorgio, Dean, Economics and Finance, LUISS University, Rome
Consigliere indipendente di Eurizon Capital SGR
For Financial Professional Use Only. Not For Public Distribution.
©2012 Morningstar, Inc. All Rights Reserved. These materials are for informational and/or illustrative purposes only. Morningstar Investment Management is a division of Morningstar, Inc., which includes Morningstar Associates, LLC, Morningstar Investment Services, Inc., and Ibbotson Associates, Inc., all registered investment advisors and wholly owned subsidiaries of Morningstar, Inc. All investment advisory services described herein are provided by one or more of the registered investment advisor subsidiaries. The Morningstar name and logo are registered marks of Morningstar. This presentation includes proprietary materials of Morningstar. Reproduction, transcription or other use, by any means, in whole or in part, without the prior, written consent of Morningstar is prohibited.
Prof. Giorgio Di Giorgio, Dean, Economics and Finance, LUISS University, Rome
Consigliere indipendente di Eurizon Capital SGR
Paul Kaplan, Ph. D., CFA, Quantitative Research Director,
Morningstar Europe, Ltd.
Dario Castagna, CFA, Investment Consultant,
Morningstar Investment Management, LLC.
Hal Ratner, Chief Investment Officer Europe,
Morningstar Investment Management, LLC.
Hal Ratner
CIO, Europe
Human Capital & Asset Allocation: Beyond the Traditional Concept of Wealth
For Financial Professional Use Only. Not For Public Distribution.
©2012 Morningstar, Inc. All Rights Reserved. These materials are for informational and/or illustrative purposes only. Morningstar Investment Management is a division of Morningstar, Inc., which includes Morningstar Associates, LLC, Morningstar Investment Services, Inc., and Ibbotson Associates, Inc., all registered investment advisors and wholly owned subsidiaries of Morningstar, Inc. All investment advisory services described herein are provided by one or more of the registered investment advisor subsidiaries. The Morningstar name and logo are registered marks of Morningstar. This presentation includes proprietary materials of Morningstar. Reproduction, transcription or other use, by any means, in whole or in part, without the prior, written consent of Morningstar is prohibited.
Hal Ratner
CIO, Europe
Morningstar Investment Management, LLC
March 20, 2012
× Defining Human Capital
× Modeling Human Capital
× Integrating Human Capital and Asset Allocation
Examples
Agenda
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× Examples
Human Capital
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Human Capital—Why it Matters
× People invest to consume
× People derive utility from planned consumption not wealth.
× Strategic asset allocation must be based on these
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× Strategic asset allocation must be based on these concepts.
Human Capital—Not a New Idea
Not A New Idea
× Adam Smith
× Karl Marx (weak form—labor power)
× Arthur Pigou
Jacob Mincer (i.e. “Investment in Human Capital and
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× Jacob Mincer (i.e. “Investment in Human Capital and Personal Income Distribution” Journal of Political Economy 1958).
× Gary Becker (i.e. “Human Capital” 1964).
× Robert Merton (1969)
× Paul Samuelson (1969)
Theory into Practice
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Human Capital
× Human Capital is market value of the skills, education, intelligence, charisma, creativity, experience, and specialized skills one brings to the labor market.
× From an economic perspective, human capital is the present
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× From an economic perspective, human capital is the presentvalue of future labor income
× Human Capital has no intrinsic value. It is continually re-priced by
the labor market.
Human Capital
Characteristics of Human Capital
× Often investor’s largest asset
× Consumed through time (e.g. younger investors have more than older investors).
× Cannot be traded
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× Cannot be traded
× Value and risk characteristics depend on age, income, gender, education, health, etc.
× Value will change as pricing variables change (e.g. more education, change in job market).
×Human Capital has no “intrinsic value” it is continually priced by the labor market.
Everyone is Different
Many people at the same age have different HC endowments
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EntertainerUniversity Professor Artist
How Stage of One’s Career Impacts Human Capital
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How Volatility of Earnings Impacts Human Capital
/Artist
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Total Economic Wealth
Financial Capital
+
Human Capital
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× Tradable assets such as stocks and bonds have traditionally been used when constructing an asset allocation
× Incomplete without considering Human Capital
× An individuals ability to earn and save
× Present value of all your expected future wages including pension and social security
Lifetime Risks: Accumulation Phase
Expense Risk Market Risk
Savings Risk
Asset Allocation Decision
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Mortality Risk
Lifetime Risks: Disbursement Phase
Expense Risk Market Risk
Bequest Risk
Asset Allocation Decision
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Longevity Risk
Typical Life Cycle of Human Capital and Financial Capital
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Risks in Accumulation
�Expense Risk
�Savings Risk
�Mortality Risk
�Market Risk
Risks in Retirement
�Expense Risk
�Bequest Risk
�Longevity Risk
�Market Risk
Human Capital & Asset Allocation
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Individual Balance Sheet
Assets Liabilities
Financial Capital
Human Capital
PV of Earnings used for Pre-Retirement Expenses
PV of Earnings directed toward Savings
PV of future Social Security and Pensions
Future ExpensesPV of Pre-Retirement Expenses
PV of Post-Retirement Expenses
PV of Bequest
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PV of future Social Security and Pensions
Surplus (Deficit)
What is the true risk of any portfolio that exists to pay for a liability?
× It is NOT the standard deviation of the asset portfolio
× It is NOT the performance of your asset portfolio relative to the asset portfolios of your peers
× The TRUE risk is that it won’t be able to pay for the liability!
Liability-Relative Optimization
× Liability-relative optimization is a special case (or extension) of traditional mean-variance optimization in which the optimizer is constrained to hold a combination of assets representing the liability short
× Assets exist to fund liabilities; therefore, liabilities and the risks associated with liabilities should be incorporated into the decision framework.
× Liability-relative optimization focuses on the entire portfolio – assets and liabilities
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Ex
pecte
d R
etu
rn
Standard Deviation
Traditional
Frontier
Liability-Relative
Frontier
× Resulting in a portfolio that better manages inflation and market risk
Typical Glide Path
60
80
100
Equit
y E
xposu
re (
%)
BondsWithin Bonds
• Long Duration Bonds• More Nominal Bonds
Within Stocks
•Higher International•Higher Emerging•Higher Small Cap Within Bonds
• Begin Shift toInflation-Protection Bonds
Within Stocks
• Average International• Average Emerging• Average Small Cap
Within Bonds
• Shorter Duration Bonds• Higher Inflation-
Protection Bonds
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0
20
40
20 30 40 50 60 70 80 90Age
100
Equit
y E
xposu
re (
%)
Stocks
20 25 35 45 55 65 75 85
Age
• Average Small CapWithin Stocks
• Lower International• Lower Emerging• Lower Small Cap• Higher REITs
Modern Portfolio Theory: Markowitz’s MVO and Sharpe’s CAPME
xpecte
d R
etu
rn
Max Sharpe Ratio
Portfolio
LT Bonds
Large Cap Stocks
International Stocks
Emerging Market Stocks
Stocks: 46%
Market PortfolioHuman Capital
(Bond-like Characteristics)
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Ex
pecte
d R
etu
rn
Retirement Income Liability
(Short TIPS-like characteristics)
Cash
Inflation-Linked
LT BondsStocks: 46%
Bonds: 54%
0
Targeting the Market Portfolio
54+
Human Capital Market Portfolio
Ú
Financial Capital
?30 46
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54+ Ú
Total Economic Wealth
?70
46
Stocks (%)
Bonds (%)
Other Considerations
× Risk capacity
× Risk preference
× Taxation
× Liquidity
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Risk Preference
Market Portfolio Definition
Conservative
+
Human Capital
Ú
Financial Capital
30
70
? ?
Moderate
Stocks (%)
Bonds (%)64
36
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+ Ú? ?
Aggressive
+ Ú? ?
4654
56 44
30
70
30
70
Risk Preference With Average Human Capital
Risky Market Portfolio60
80
100
Equit
y E
xposu
re (
%)
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Average Market Portfolio
Conservative Market Portfolio
0
20
40
20 28 36 44
Age
60
Equit
y E
xposu
re (
%)
52 68 76 84
Hedging Mortality Risk
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Life Cycle of Human Capital – Hedging Mortality Risk
$800,000
$1,000,000
$1,200,000
Insu
rance N
eed
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$0
25 30 35 40 45 50 55 60 65
$200,000
$400,000
$600,000Insurance Need
Insu
rance N
eed
Age
Life Insurance
Questionnaire
used to assess:
Life Insurance Questionnaire – Hedging Mortality Risk
Financial Situation
×Financial Wealth
×Current income level
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Subjective Factors
×Human Capital
×Consumption vs. Bequest
Hedging Mortality Risk
Human Capital
Asset AllocationDecide if need Mutual Funds, ETFs, Separate Accounts
Inputs Outputs
Financial Capitaland Current Savings
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Questionnaire Collect info such as: age,income, bequest preference, dependents, life expectancy, risk tolerance
Ins Life Insurance Face Value CMA
Capital Market Assumptions
and Current Savings
Total Economic Wealth
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Case Study
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Case Study
Joseph Horton Account Manager Advertising firm
Children 2
Profession
Wife, School Teacher
Teenagers
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Case Study – Joseph Horton
Your Human Capital is estimated at $1,900,000. This is an assessment of the present value of your expected future labor income including applicable Old Age Security and pension benefits.
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pension benefits.
Case Study – Joseph Horton
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$600,000 Face Value
Target Maturity Glide Path Style Box
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Conclusion
× Human capital is the sum total of one’s skills and is represented as the present value of future labor income
× Human capital is often an individuals largest asset
× A better understanding of human capital allows us to make better financial decisions and apply our skill sets more appropriately
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financial decisions and apply our skill sets more appropriately
× Consider the current value of your clients human capital when constructing their financial portfolios.
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