Income stability matters in your portfolio

(MoneyWatch) When designing your investment plan and asset allocation, accounting for your unique ability, willingness and need to take risk is of utmost importance. However, when looking at your ability to take risk, you also need to account for how stable your income is.

Accounting for your willingness and need to take risk is fairly straightforward:

• The more "stomach acid" you can absorb during bear markets without abandoning your plan, the higher your allocation to stocks can be.
• The higher the rate of return you need to meet your financial goals (and the more you convert desires into needs) the higher your allocation to stocks must be.

The ability to take risk is more complex. Most investors focus on their investment horizon when thinking about their ability to take risk: The longer the horizon, the greater the ability to take risk and the higher your allocation to riskier stocks can be. However, the issue is more complex. As I discuss in The Only Guide You'll Ever Need for the Right Financial Plan, your ability to take risk is determined by not only by your investment horizon, but also your need for liquidity. You also have to consider if you have options that can be exercised should bear markets create a need to implement a "Plan B" (such as cutting spending, working longer, lowering the goal) that would prevent the portfolio from "failing" (leaving the investor without assets sufficient to meet their needs).

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However, the stability of your labor capital is often overlooked, even by many advisors. The greater the stability of earned income, the greater the ability to take the risks of owning stocks. For example, a tenured professor has greater ability to take risk than either a worker in a highly cyclical industry where layoffs are common or an entrepreneur owning a business with cyclical earnings. The tenured professor's earned income has bond-like characteristics. All other things being equal, she has more ability to hold stocks. The entrepreneur's earned income has stock-like characteristics. He should hold more bonds.

Since labor income accounts for about two-thirds of national income in the U.S., it should play an important role in determining asset allocations for most people. In fact, an important role of capital markets should be to allow individuals to hedge the risks of their labor capital. The study, "Hedging Labor Income Risk," was conducted using investors in Sweden and examined whether changes in the wage volatility of households (as workers switched industries) led to changes in portfolio holdings.

The study found that households do adjust their portfolio holdings when switching jobs, consistent with the idea that households hedge their human capital risk in the stock market. The effect was especially strong for job changes that led to large swings in wage volatility: A household that experienced an increase in wage volatility of 20 percent decreased its portfolio share of risky assets by 20 percent.

A household going from the industry with the least variable wage to the industry with the most variable wage (all else equal) decreased its share of risky assets by up to 35 percent, corresponding to the workers' hedging demand for aggregate labor capital risk.

The study's authors also found that an increase in net worth led to a significant decrease in the allocation to risky assets. This too is logical as increases in net worth lead to reductions in the need to take risk. In addition, while more wealth is always better than less, the marginal utility of wealth declines as wealth increases. (This means that you have enough at some point and it's not worth taking the risk to try and create more.) So once again, we see Swedish investors acting rationally, putting portfolio theory to work.

There's one interesting conflict that should be pointed out. While investors hedged their labor capital by shifting their stock holdings as the volatility of their labor capital changes, they tended to hold stocks that were closely related to their labor income, especially the stock of their employer. This is contrary to the hypothesis of hedging of labor income risk. It seems that the familiarity bias is too hard to overcome for most investors.

Hopefully you're following the example of Swedish workers, incorporating labor capital risk into your investment plan. However, if your plan doesn't incorporate your labor capital, you should reconsider your asset allocation, taking it into account. If you've made the mistake of playing the game of "double jeopardy" by investing in the stock of your employer, that's a mistake you should correct ASAP. And if you've changed jobs since your plan was created, altering the volatility of your labor capital, you should revisit your plan. Finally, if you don't yet have a plan, the very next thing you should be doing is creating one.

Image courtesy of Flickr user Tax Credits.