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The Big Picture

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There used to be a commercial for kosher franks which checked off all kinds of chemicals, dyes, meat byproducts and other additives the government allowed in hot dogs. But not in this brand, a voice-over solemnly declared — “because we answer to a Higher Authority.”

Who: Moshe A. Milevsky, Finance Professor, York UniversityWhere: Colbeh, 43 West 39 Street, New York, September 10, 2008 On the Menu: Grilled, cubed prime beef, basmati rice and an investment strategy including human as well as financial capital.

Lunching at a Persian kosher restaurant surrounded by black-clad Chassidim from the nearby clothing and diamond districts, Prof. Moshe Milevsky and I should probably feel a little more spiritual. But bears prowling Wall Street three miles to the south of us keep intruding on our conversation.

“Of course stocks remain the best long-term investment,” says Milevsky. “In the long run, you’ll come out ahead as long as you don’t take any money out. If you stick to your dollar-cost-averaging strategy in a bear market, you’ll do even better because a bear market is the best time to buy. But it’s small consolation if a third of the value of your portfolio is gone just as you’re about to retire.”

For investors nearing retirement, the traditional risk-reward tradeoff, when you get higher returns but pay with higher volatility, doesn’t quite work. Their tradeoff is different. It is how much income you’re going to retire with vs. when you retire. In other words, the longer you keep on working, or the more flexible you are about the date of your retirement, the more money you’ll have in retirement.

A downdraft in the stock market makes this tradeoff even more difficult. The choice of retiring at a set date becomes very costly. Milevsky fears a rerun of the problem of the early 2000s, when in the aftermath of the Internet bubble many people saw their nest egg suddenly diminish and had to go back to work. “They had to go to McDonald’s, but this time to work, not to eat,” he jokes grimly.

This time the issue may be compounded by the numbers of baby boomers reaching their golden years and by the fact that they will live longer and spend considerably more time in retirement than their parents. It is all the more important to understand, therefore, that how prosperous and care-free your retirement is may depend less on how much money you have and more on how you deploy your financial capital.

It is a difficult problem but Milevsky proposes a comprehensive — and a somewhat holistic — view of asset allocation.

Personal and Financial RiskThere is a joke that classifies different types of boyfriends as different types of investments. Reliable ones tend to bring low emotional returns whereas high-payoff beaus tend to be more volatile.

However, Milevsky is dead serious when he suggests that this is how we should look at ourselves, too — at our careers and earning power. In fact, he wrote a book about it, which has recently been published by FT Press under the title Are You a Stock or a Bond?

It may be a stark way of looking at one’s life, especially when investors are indiscriminately dumping stocks. At least Milevsky declares himself to be a bond. He refers, of course, to his steady, reliable but by no means spectacular income as a finance professor at York University in Toronto. He has tenure, which provides secure payments all the way to maturity — i.e., retirement. The coupon on the bond called Prof. Milevsky will increase over time, but not by much. On the other hand, he is a highly rated bond, unlike the mortgage-backed securities that got the U.S. financial system into so much trouble. There is very little chance that his job will be terminated or, in other words, his salary will be diminished or stopped.

“Since my human capital is all a bond, I don’t own any bonds in my investment portfolio,” confesses Milevsky. “I only hold stocks, and I can even afford a somewhat leveraged stock position.”

Not so the future finance whizzes he teaches at York. They want to work for large, reputable Wall Street firms such as Bear Stearns and Lehman, chuckles Milevsky. “I tell them that they should invest in bonds because they already have plenty of stock-like behavior in their professional lives.”

Sound Advice The concept Milevsky relies on, human capital, may not be all that original, going all the way back to Adam Smith. But he has refined it cleverly by looking at human capital as an asset and defining the risk/return characteristics of different asset classes of human capital. It also provides a valuable insight on how to approach one’s investment portfolio.

Taking into account human capital allows Milevsky to dispel several common myths. For example, most of his students who leave college with little money, having maxed out on their credit cards and taken on huge loans, think of themselves as very poor. Milevsky tells them that they are the richest they’ll ever be.

That’s because they may not own much financial capital as yet, but they have the most human capital they will ever have. Human capital can be used to earn financial capital — but not the other way around, which makes human capital much more valuable.

Looking at the entire range of one’s assets, human as well as financial, should provide a better understanding of one’s overall exposure and help to design a more effective investment strategy, even though he admits that individual temperament may prevent the selection of the best strategy.

“A teacher working for a public school system is definitely a low risk bond as far as her human capital is concerned. Her advisor should be telling her to take on greater risk in her financial portfolio. But of course people who go into a low-risk career also tend to be conservative with their investments.”

Regardless of how you have accumulated your financial capital, Milvesky’s idea could get you useful insights into how you need to manage your financial capital when you retire. The problem is that when you reach retirement age, your human capital is nearly gone, he says. This is why if a retiree is forced to return to the workforce he or she has to settle for a minimum-wage job at McDonald’s or greeting visitors at Disney.

Many retirees are facing the challenge of living longer than they anticipated when they first began saving for retirement. As octogenarians or even nonagenarians, they can expect their human capital to decline to zero. Yet, they may live long enough to see their financial capital also dwindle.

“Today’s retirees can’t be greedy,” declares Milevsky.

In addition to having to wait for a more propitious situation in the financial market, he believes retirees need to give up some of their financial capital up-front to buy such things as long-term care insurance and annuities extending far into the future. Otherwise, they run a very real risk of outliving their money.

This is what Milevsky would like retirees to hear from their advisors. Instead, he says bitterly, he recently heard an interview with a personal finance guru advising investors to take a look at whether they have any Fannie Mae or Freddie Mac in their portfolios.

“That they should have done long before their shares were de-listed from the Big Board,” he complains.

Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at [email protected]. His monthly “Global Economy” column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past five years, 2004-2008.


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