3 Reasons It Makes Sense for Me to Be Invested 100% in Stocks

Welcome to 5 mins to Financial Freedom, a weekly newsletter where I share with you the most impactful articles I have ever written to help you make, manage and invest your money in pursuit of financial freedom.

For exclusive tips on reaching financial freedom, subscribe to my Substack for free.

The factors I considered when deciding to invest heavily in stocks

One of the most important investment decisions you can make is how to balance your portfolio. Meaning, how much of your portfolio should be allocated to risky assets like stocks and risk-free assets like bonds?

Most financial advisors will make a recommendation based on your “risk tolerance” and your years to retirement. The idea is that if you have a long time until you retire, you have plenty of time for your investments to recover.

The conclusion tends to be that the younger you are, the more you should weight your portfolio towards risky assets like stocks. While that conclusion is the right one, it has little to do with the amount of time your investments have to recover from a crash.

The rational way to approach asset allocation is based on what economists call your “human capital.” which is a fancy way of saying your ability to earn money. How many years of work you have left and the level of security you have in your income are the most important factors to determine your asset allocation.

In this article, I discuss how your ability to earn money impacts an optimal asset allocation and the three factors that lead me to a 100% allocation to stocks.

Three factors that explain why I should be invested 100% in stocks

1. My wife and I each have high job security and extremely predictable income.
2. We are lucky enough to each have Defined Benefit (DB) pensions through work, which means our retirement income will be very secure and extremely predictable.
3. I am relatively young at 32 years old, which means I have a lot more income I will earn in my life through my human capital.

Let’s dive into each of these factors and explain how they impact my allocation between stocks and bonds.

Are you a stock or a bond?

In his book “Are you a stock or a bond,” author Moshe Milevsky challenges readers to consider if their human capital is high-risk, high-reward like investing in stocks or provide predictable fixed-income similar to a bond.

• If you own a business or work a 100% commission sales job, your human capital would be stock. There is no limit on the potential returns, but it could also come crashing down to $0 one day.
• If you are a tenured professor, your human capital would be like a bond. The same amount of money hits your bank account each month, with a small chance of getting fired but with a cap on your earnings potential.

If your job is high-risk, high-reward, your human capital acts like a stock. If you have relatively high job security and predictable pay raises, your human capital acts like a bond.

How your human capital impacts asset allocation

Thinking of our human capital as either a stock or a bond helps us when deciding how much of our financial capital to allocate to stocks and bonds.

• If your human capital is a stock, it makes sense to allocate more of your financial capital to bonds or other fixed-income assets. That way, you have some income to fall back on if your income goes away.
• If your human capital is a bond, it makes sense to allocate more of your financial capital to stocks. That provides you the potential growth and upside that your human capital does not.

As I stated already, my wife and I have very high levels of job security, and we know exactly how much money we will make each year.

Our human capital acts like a bond, which means we need to be overweighted towards stocks with our financial capital to balance out our portfolio of total wealth.

“Overweighted towards stocks” does not mean that this one factor means we should be 100% in stocks; that’s where the other two factors come into play.

Does your job security impact your investment decisions? Let me know in the comments. I’m really interested to hear how people think about that question.

My wife and I each have Defined Benefit pensions through our employer

Not only does our human capital look like a bond, but our retirement income also looks like a bond.

If you’re unfamiliar with how a Defined Benefit pension works, it is a retirement savings tool that provides employees a guaranteed stream of passive income in retirement.

This in contrast to a Defined Contribution retirement plan, like a 401k, which helps employees accumulate assets but leaves it up to the employee to figure out how to convert those assets into income when they retire.

A Defined Benefit pension acts like a bond whereas Defined Contribution retirement plans act like a stock

So, once again, my wife and I are overweighted to bonds, which further strengthens the case to overweight our financial capital into stocks.

Our human capital outweighs our financial capital

I saved this point for last because it is the most complex/“economics nerdy” issue I have written about in a long time.

Let me start with a brief definition of how “Present Value” calculations work.

Present Value is the current value of a future lump sum or stream of cash flows.

Putting a present value on your career earnings is simply figuring out how much money I would need to pay you today to never work again and have you just as well off financially as if you continued working until your planned retirement age.

You might be a millionaire and not even know it

Let’s assume the following.

• Current age: 30.
• Desired retirement age: 65.
• Current income: $60,000.
• Your income will rise at the rate of inflation.

How much money would I need to give you today and quit your job for you to be just as well off financially by the time you reach age 65?

Assuming a discount rate of 0.12% (current yield of a 2-year U.S treasury at the time I write this,) I would need to give you just over $2 million. The present value of your human capital in this situation would be more than $2 million.

The only problem with your human capital is that it is the most illiquid asset you will ever own; most of us only get to access a tiny piece of our human capital every two weeks.

The same type of Present Value calculation can be applied to a Defined Benefit pension plan, which simply gives us a stream of cash flow starting at a specified date in the future.

My wife and I are fortunate enough to make more than $60,000 per year, and we each have a Defined Benefit pension plan at work.

If we were to calculate the Present Value of our combined human capital and future pension income, it would be worth millions of dollars.

Since our human capital and pensions act like bonds, that means we have millions of dollars worth of bonds in our total portfolio of human capital + financial capital.

When we consider the Present Value of our human capital we are heavily overweighted towards bonds, so the rational choice for us is to invest 100% of our financial capital in stocks.

These numbers will change over time

Just because the current optional allocation for us is 100% in stocks does not mean this will always be the case.

Two factors drive up the Present Value of our human capital.

1. We are young, which means we have a lot more human capital than we will when we are old.

Think of your human capital as an oil refinery that spits out a certain number of barrels every two weeks. As time goes on, the total pool of oil underneath the refinery diminishes until one day, there is no more oil to produce.

2. Interest rates are at historic lows, which lowers the discount factor. If interest rates rise, the Present Value of our human capital will fall.

Three questions to ask yourself when considering your allocation between stocks and bonds

1. Does your human capital act more like a stock or a bond?
2. If you’re lucky enough to have a workplace retirement plan, does that plan act like a bond (a pension) or a stock (defined contribution plan.)
3. What is the Present Value of your human capital? Or, at the very least, ask yourself how many working years you have left?

If you’re a 22-year-old government employee, you’ll probably want to overweight towards stocks.

If you’re a 64-year-old business owner, you’ll probably want to overweight towards bonds.

The rest of us are somewhere in between these two extremes. But as a general rule, the younger you are, the more you should be invested in stocks.

Not because you have time to recover from a stock market crash, but because you have such a large amount of human capital compared to financial capital.

As you age and your human capital diminishes, it makes sense to transition more towards a higher allocation of bonds.

If you found this article useful, you may want to enroll in my free “investing-101” course available right here.

This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.