Total Portfolio Approach: How to Consider Careers in Stock Portfolios

No portfolio is an island. Financial assets, like stocks and bonds, often comprise a small portion of an investor’s total economic worth.

By overlooking human capital, financial advisors might be ignoring an important source of risk at the total portfolio level.

For instance, an oil executive has significant exposure to the fortune of one company and industry through their salary, unvested stock grants, and future bonuses. If the company falters, the executive could feel it in all those places at once.

How should your stock portfolio consider your career? To answer this question, Morningstar reviewed data from 2013 to 2022 with a sample of 263 American firms.

For the full study and its methodology, download the total-portfolio research report. For financial advisor use only.

Human capital is the value of a person’s future earnings. It includes cash wages, benefits like health insurance, and any stock compensation. Its value varies depending on a person’s skills, occupation, age, industry, or employer.

Research shows that human capital comprises a weighty portion of a person’s overall economic worth. One study estimated that human capital makes up 48% of household wealth, while financial assets only represent 6.8%.

A growing body of evidence shows that labor income, or the return on human capital, correlates with financial assets. And not just at the C-suite level, either. Many companies now offer stock-based compensation as part of their overall package.

Restricted stock units create a financial incentive for employees to add business value. The better company stocks perform, the more employees can earn. For startups with limited cash flow, stock-based compensation can lure talent away from other high-paying roles.

The combination of stock compensation and future earnings makes careers a hefty portion of overall net worth. Failure to consider career risk can have major consequences.

Under capital asset pricing theory, economists posit that investors should diversify idiosyncratic risk. Unlike market risks, these are not systematically rewarded with higher returns, and do not come with a risk premium. These idiosyncratic risks may still be correlated with other assets—in this case, with human capital.

As an example, consider the recent bankruptcy of Silicon Valley Bank. SVB stock made up 18% of the retirement plan assets of their employees. When workers lost their jobs, they also took a major hit to their net worth. In hindsight, it’s clear that SVB employees’ total wealth was overly exposed to firm-specific risk.

While employer-specific risk is hard to eliminate, given the relative size of human capital in the average investor’s total wealth balance sheet, a better-diversified investment portfolio could have reduced the economic impact of SVB’s bankruptcy on employees.

Human capital risk is closely intertwined with firm-level risk. The value of a client’s future earnings is tied up in firm-dependent factors, like:

• Career growth opportunities.
• A firm’s prestige.
• The ability to transfer to other positions.
• The likelihood of experiencing layoffs.

On their own, simple exclusionary approaches won’t work to diversify portfolio risk, our study found.

If an investor working for Apple excluded the company from their investment portfolio, for instance, the choice might not be meaningful on its own. A client’s employer might not be in major market indexes, making the exclusion useless.

On the other hand, sector exclusions are so broad that they could affect portfolios in other ways. If an Apple employee excluded information technology stocks from their portfolio, it would have major implications for risk and return.

We find that companies with low earnings yield, low leverage, and large market capitalization pay a greater proportion of their staff expense in equity shares.

Clients with some of the conditions below could benefit from portfolio optimizations for their career.

• High level of stock compensation.
• Risky startups.
• Companies with a high level of idiosyncratic risk.
• Volatile industry sectors.
• Companies with material credit risk.

Direct indexing has taken the investment industry by storm. Part of its allure is the idea of personalization at the security level. However, it only makes sense to customize a portfolio if it helps investors reach their goals. Direct-indexing solutions need robust frameworks to guide investors’ decisions.

In our study, we found that wealth optimizations significantly reduce idiosyncratic portfolio risk, improving risk-adjusted return at the total portfolio level compared with a cap-weighted index. Additionally, we show that total wealth optimizations materially reduce correlation with firm-level human capital and restricted stock units.

Download the full research paper for:

• A novel approach to modeling firm-level human capital.
• A total wealth framework for holistic portfolio construction.
• Results from our wealth optimization study on 263 US firms.