When I attend cocktail parties, networking events or even gatherings like my nephew’s graduation, I undoubtedly get asked the same thing over and over again: Should I buy ABC stock? Should I invest in XYZ?
They’re great questions indeed. No doubt about that.
The problem is that no human being can offer an appropriate answer without a whole lot of background knowledge about the person posing the question.
An adviser must have a rounded-out picture of the investor to offer a valuable assessment.
To gain that fuller understanding, the adviser and investor must consider more than the typical metrics, such as portfolio diversification or levels of debt.
They must construct a complete inventory of the investor’s financial situation that includes often-overlooked items like the value of his labor or the investor’s plan for maintaining his lifestyle during retirement.
Simultaneously, the adviser and client must understand implicit factors about the client’s situation, such as the nature of his assets and liabilities. Then and only then will the adviser and investor be able to engage in the primary task of wealth management: to manage risk.
For most people, the term “wealth management” is about maximizing returns. For me, wealth management is about risk management. You can have risk management without wealth management, but you can’t manage wealth without managing risk. It’s plain and simple.
What Items are Missing from Your Personal Balance Sheet?
Many wealthy people are pros at running their businesses, investing innumerable hours and resources in full analyses of industry and market indicators. But these same people often do not analyze their private holdings with the same sophistication, usually because they rely on their brokerage statements as their primary source of information.Yet our brokerage statements do not include some of our most important assets and cannot provide a full overview of an investor’s financial position.That’s why I advocate using a personal balance sheet that provides an inventory of assets and liabilities in today’s dollars that can highlight an investor’s leverage ratios and inform investment decisions from a risk perspective.
This is my preferred approach over a cash flow analysis in which cash inflows over time, such as wages, are compared to cash outflows over time. Such methods allow an investor to see where inflows and outflows match up and where they fail to match up, but they often mask some dimensions of risk.
Still, a personal balance sheet may not tell the whole story because the “character” of the items it contains may not have been considered, and investors may have overlooked certain items. On the asset side, often-overlooked items include defined-benefit plans, Social Security income and the value of your labor. Often-overlooked liabilities may be the expected costs of health care and maintaining your chosen lifestyle during retirement.
Calculating the Value of Your Labor
Before we tackle the character of assets and liabilities, let’s look at the value of your labor as an implied asset that may be missing from your balance sheet. We could call it your human capital or employment capital, if you will. For most people, the value of their employment exceeds the value of their assets by a wide margin, and this asset has some special characteristics that make it differ from typical items on a balance sheet or brokerage statement. For instance, labor is usually undiversified, and the value of your labor is illiquid. You cannot call your broker and say, “Sell everything I’ve got!”
Despite labor’s illiquidity, it’s still worth it to calculate the value of your labor and plug it into your balance sheet, because understanding this number helps you gain a fuller picture and thus better engage in risk management.
There are a number of ways to measure this and it gets complicated easily, but it’s better to be approximately right than totally wrong by not including the asset. The simplest approach is to use a basic present –value calculation.
If a person earns $100,000 a year, she might expect her salary to grow at 5 percent per year for the next 20 years that she plans to work. Using a 7 percent discount rate, the value of the woman’s human capital would be $1.5 million, and she may decide to add this figure or an adjusted version to her balance sheet. Now you see why I say that the value of most people’s labor exceeds their assets by a wide margin.
Before we move on, I’d like to qualify one point here. It’s the matter of how you choose the discount rate to use in calculating the value of your employment. To make the right choice, you’ll have to consider the nature of your employment – i.e. whether it is more like a bond or a stock and whether it is diversified.
If you are a tenured university professor, I’d assign a very low discount rate to your calculation because your labor is very safe. It’s bond-like. On the other hand, if you work in financial services and your employment is linked to macro-economic factors, then your labor’s character is closer to that of an equity investment. I’d use a higher discount rate in the calculation.
The Nature of Your Assets and Liabilities
In general, I caution people going through this exercise to be somewhat conservative in their assumptions, given the overall market and economic turmoil we have experienced since the financial crisis of 2008 and the uncertain economic future we face. But don’t overlook the value of your labor: If you do, you’ll fail to fully understand your risk exposure and risk tolerance.
Another point to consider about human capital is its typically undiversified nature. Look at it like this: If you’re a real estate developer, your human capital expertise and your business are already tied to the fortunes of the real estate market. You’re probably over-exposed to real estate and you may want to underweight the industry in your investment portfolio or even go short on the sector to provide yourself with a hedge. Many investors fail to consider this as they make choices.
What we’ve done here besides fill in missing assets is examine items in terms of their character. In this vein, you may want to go back through your balance sheet and consider the question of character for all your items. For instance, some people forget to keep in mind that defined-benefit pensions and social security tend to be bond-like in nature, inflation- adjusted and longevity-protected. These are very important characteristics in a risk-management context.
Which Liabilities are Lurking Just Off Your Balance Sheet?
Now for liabilities that are often missing from a balance sheet. If we want to be consistent with our approach here, we have to recognize how we want to spend money as a liability. You’ll never get a statement from the bank saying: “This is the money you owe yourself for the retirement you want to live or the medical expenses you’ll have.”
But you can estimate the amount of money you’ll want. Here, too, you can see how setting it up on a balance sheet allows you to better examine the nature of the liability. You can think about the liability in terms of risk exposure, and if you determine that there’s too much uncertainty regarding health costs, for example, you can explore how to manage that risk, perhaps through a long-term health insurance plan. I’m not saying that everyone should go out and buy this type of policy; I’m suggesting that investors make decisions within such a risk-enlightened framework.
We must keep in mind that the value of our assets as well as our liabilities will go up and down over time as interest rates, inflation, economic prospects and personal circumstances change. The ideal goal is to structure assets so that they fluctuate in the same way as liabilities so that the difference between the two is less volatile. Yet most of us focus only on the assets.
Finally, I’d like to wrap it up by commenting on the liquidity of assets as a risk factor. Ask yourself: Is your balance sheet well-funded enough for your future obligations, such as the lifestyle you want to maintain during retirement? Or is all your net worth tied up in a house or another illiquid vehicle that is difficult to break up into small parts and sell off?
It very well may be that your expected lifestyle costs will outstrip your assets. If so, this should be your wake-up call to limit risk and submit to the humble rules of arithmetic: the rules that many people just don’t want to face. You are living close to the edge, and you have no cushion.
If, on the other hand, you are well-funded and you’ve got enough assets to accomplish your goals, then you are in the fortunate position to consider more risk.
[For more information on conducting a financial inventory, please see the Building Capital chapter of The Forbes/CFA Institute Investment Course and take the quiz about Chapter 1. If you already have a personal balance sheet, I recommend updating it once a year or after major life changes.]
-With Rhea Wessel, a personal finance writer based in Frankfurt.
