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Wednesday, June 16, 2010

"How to Think Smarter About Risk"

Moshe A. Milevsky's thought-provoking article "How to Think Smarter About Risk" is must reading for the investment community. His thesis is that human capital is an asset that should be included on the personal balance sheet and incorporated into the asset allocation process. As he puts it, some people are bonds--their incomes hold up even in the face of a 20% market drop--and others are stocks--their incomes go up and down with big changes in the market.

His most controversial premise, it seems to me, is that young people should go lightly on equities because of their erratic income, and vice versa for older people who have converted considerable human capital into financial capital and thereby can take on additional risk. This, of course, is exactly opposite of accepted views on asset allocation. It seems to me that there is a trade-off involved in the point made by Milevsky and the long term returns of risky asset classes.

On another note, his analysis leads me to think that people should think a bit harder about the role of their home in their long-term financial plan. Is it viewed as an asset that will be used to help fund retirement? Then the possibility of a drop in price(or rise in price) should be factored in, whether from the possibility of a reverse mortgage or downsizing.

In any event, Milevsky's analysis raises important points in the critical area of risk management.


  1. This is an interesting perspective indeed. I was just having a similar discussion about asset allocation with respect to age with another blogger a couple days ago. I think it all depends on your overall plan and your risk tolerance. If you need the money within 3-5 years (regardless of whether you are young or old), then you probably don't want the money in stocks. Rigorous evaluation of your whole financial picture does infinitely better than widely accepted rules of thumbs in my opinion.

  2. Agreed. If needed within 5 years keep it out of stocks. I saw people get caught in 2008 with 529 plans.