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Don't Invest with an "Island" Mentality

The result of an "island" mentality is a portfolio that isn't fitted to the individual for maximum efficiency. A lot is made about efficiency within investment portfolios, but no portfolio can be efficient without considering an investor's total wealth. No man is an island, as Donne said, and neither is a portfolio.

A recent MarketWatch article, titled "No man is an island, as Donne said, and neither is a portfolio," explored the "island" perspective to asset allocation and why you shouldn't invest in this way. Why? Because the portfolio is examined in isolation and does not consider the investor's "total wealth." By contrast, a total-wealth perspective encompasses an investor's other assets, such as human capital, real estate and potential pension benefits-each of which has unique risk factors. As a result, the concept of "background risk" is important to consider when building a portfolio.

Human capital is the total economic value of an individual's skills and talents and is estimated as the present value of future wages. It is seen as a way to quantify a person's earning ability. The riskiness of human capital is based on an individual's occupation and industry; however, it is typically considered a relatively bond-like asset. Human capital can be the largest asset in younger individuals' total wealth portfolios, suggesting that portfolios of these individuals should be more aggressive than those of older people (with less human capital) and the reason why target-date fund providers suggest a decreasing equity glide path as an individual approaches retirement.

The original article also says it is important to consider the relationship of human capital to different investment assets and that it applies especially to holding stock in your employer. A negative event for the company (something economists call a "shock") could cause an individual's investment capital and human capital (job loss) to fall simultaneously. Enron is a good illustration, where former employees found out that, not only were they out of work, but their 401(k) savings were cut in half as over 50% of the plan's assets were invested in Enron stock.

So, do not try to invest with an "island" mentality, a portfolio that is not set to the individual for maximum efficiency. No portfolio can be efficient without considering an investor's total wealth.

For more information, please visit my estate planning website.

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