The following is a guest post from Vik Tantry, the voice behind Kanjoh, a directory of free videos explaining the fundamentals of asset allocation, personal finance, and banking. The thoughts below are interesting concepts, similar to what I've shared in This Seems Like a Bad Idea to Me and Ouch! Here's a Reason You Need to Be Very Conservative in Retirement Planning.
Diversification is important for most individual investors. We hope to reduce risk by investing in a wide variety of asset classes. However, in designing our portfolios, we often ignore one of our most important assets: our job and career.
For most people, their job is their primary source of income. Income potential in a job is largely driven by profit and growth within the industry. But what if things start going badly and it becomes harder to make ends meet? In this case, it would be great to have some investment gains to offset the loss in income. This will help smooth out an investor's cash flow over the long run.
How can this be achieved? Let's illustrate with an example. Phil is a real estate broker with more than twenty years of experience. He understands the ins and outs of the real estate market, and knows that real estate tends to move in cycles. When times are good, he will be able to generate significantly more income than when things get bad. Therefore, to smooth out his returns, Phil devotes a small percentage of his portfolio to short-selling a local real estate investment trust, a fund that actively buys and manages local properties.
In the boom years, Phil's income goes up due to an increased number of sales, while his short position will result in a loss. However, if the real estate market goes south, the short position will start increasing in value. This capital gain will help hedge away some of Phil's loss in income. As a result, Phil can sleep soundly knowing that he has at least some level of protection against a market collapse.
This strategy of "betting against your career" seems counterintuitive. Many of the most successful investment managers recommend "investing in what you know." After all, you are likely to make more informed decisions if you understand the context of an investment opportunity. While this may be true for professional, full-time investors, the next example illustrates that this strategy can in fact lead to a dangerous level of overexposure.
Like Phil, Josh is an experienced real estate broker who understands the fundamentals of the industry. Josh decides to use his knowledge to speculate on the local real estate market. He starts by purchasing one house, then two, and then five. Because the market is going up, Josh can easily borrow the money to finance his investment decisions.
But all of a sudden, the local market experiences a sharp decline. In the course of a year, Josh's properties fall nearly 30% in value. He would incur large losses if he sold right away, so instead he chooses to continue making the monthly mortgage payments. However, the rough market makes it difficult for him to sell houses. The decrease in income, high monthly payments, and decline in housing value all lead to a cash crunch.
Hedging against loss of income is not limited to the real estate market. Software engineers should protect themselves against a tech bust, and financial analysts should hedge against banking collapses. After all, the last thing you want is to lose your job and savings in one fell swoop. Instead, a carefully constructed strategy of considering your job as part of the investment decision can help avoid such calamities and reduce your overall risk.
This is an interesting perspective. The biggest risk these days is people who hold the bulk of their portfolio in their employer stock. If your job goes, often those shares go to (restricted shares, stock options for example) and therefore a double hit on your future income.
The Dividend Guy
Posted by: The Dividend GUy | July 31, 2009 at 12:55 PM
I don't know if I would recommend actively betting against your career but I would certainly take your income and job sector into consideration when setting up the diversification of your portfolio allocations. I take the same consideration currently with my home equity as a portion of my real estate sector allocation.
Posted by: MonkeyMonk | July 31, 2009 at 01:55 PM
The WSJ has a good article on the concept of hedging, but applied to stocks. I thought it explained the value of adopting a hedging strategy very well. http://online.wsj.com/article/SB10001424052970204619004574320723969510260.html
Posted by: brooklyn money | July 31, 2009 at 02:57 PM