Are You a Stock or a Bond?

No, there isn’t a mistake in the above headline. I am not asking whether you own stocks or bonds.

What I am asking here is – Are ‘YOU’ a stock or a bond?

This is the very first question you must answer before you get down to investing in the stock markets. But before that, you must be very clear about these two basic questions:

• What is a stock?
• What is a bond?

A stock is a share in a company, and thus its performance is dependent on how the company’s business does.

In short, a stock’s future performance is unpredictable. This is because it is backed by a company that has inconsistent earnings (in most cases) and subsequently inconsistent performance.

A bond, on the other hand, is a financial instrument that is issued when a person lends money to another person. By issuing a bond, the borrower promises to repay the money after a certain interval (without any default), and also promises to pay a certain interest on the borrowed amount.

So, a bond guarantees a regular income (in the form of interest) and a confirmed payout at the end of a predefined time.

Now, coming back to the same question – “Are you a stock or a bond?”

The answer lies in understanding yourself – your life, and your career.

You are a bond if you have a stable job that is unaffected by the volatility of the stock markets. And you have many years left to work.

On the other hand, you are a stock if you have little years of work ahead of you, or if you work in a volatile and unpredictable field that could decline quickly with little notice (like the stock markets itself!).

What this stock/bond question answers is how you look to the idea of integrating your ‘human capital’ with your ‘financial capital’.

It answers how you can integrate your work outlook into our investing and financial plan.

Human capital in this context is the current value of your long term earnings. When you combine that with your financial capital or savings, it equals your total wealth.

While answering this question must be the first step to starting out on a financial plan, few of us take our human capital into account when allocating our financial capital.

We all worry about the market risk, economic risk, political risk, and inflation risk. But we never give an iota of thought on what we can call the ‘personal risk’?

And what’s your ‘personal risk’?
Well, it depends on two things:

1. Your age
Let’s talk about the age factor first. The younger you are the greater is your human capital (though your financial capital might be less).

While many would see a young person as a ‘growth stock’ – full of energy with bursts of higher earnings (income) – he in fact has a better match with a ‘bond’.

This is because he has many years of work ahead of him so he has a long time at his disposal to earn and save. His human capital is high.

To balance that out, as a general rule of thumb, a young person should hold his financial capital in more aggressive investments (like stocks and equity mutual funds).

On the other hand, a person close to retirement or one who is already retired is at the opposite end of the spectrum.

He has used up his human capital and most probably has lots of financial capital to ride out the rest of his life.

Given his low human capital, he should balance out his investments by investing in safer investments (like bonds and fixed deposits).

2. Your job (or work)
This is the second element that defines your human capital. What you do for a living also defines if you are bond or a stock.

If you are a banker, doctor, government employee, teacher, or a professor, you resemble more like a ‘bond’.

These jobs are relatively stable and are not generally impacted by whatever’s happening to their financial capital (in times of a financial crisis).

Even in times of stock market or economic turmoil, the incomes of those involved in these jobs are regular (like a bond).

In effect, their human capital is high. So, to balance, they have the flexibility of making the rest of their portfolios (financial capital) a little more risky.

On the other side of this lie the ‘stocks’ – those working as investment bankers, economists, stock market analysts, fund managers, derivatives trader, financial advisors, or small businessmen.

These people earn well when the economy is doing good. But a bad economy or stock markets can be a nightmare for them.

And even if they consider them as bonds, they mostly represent junk bonds – having a high dividend yield (high incomes in good times) but with a significant default risk (when times turn bad).

If you are one of these, or are working in an industry that is closely related to how the stock markets or small businesses do, you may want to make the rest of your portfolio a little less risky as a counterweight, by investing a greater share of your financial capital into safe instruments.

If you work closely with the stock markets, you might argue – “But since I am ‘in’ the market and if I know that the market is due to rise, shouldn’t I invest more into stocks and less into bonds?”

Well, your view that the markets are going to rise does not matter much here.

This is even if you think you can emotionally stand the ups and down of stocks.

You should instead be considering that if markets decline over a prolonged period of time, there is a greater chance you might lose your job, and be unemployed for a long time.

Remember that your human capital – with your monthly paycheques being the dividend on this capital – is already ‘in’ the market. You probably can’t afford to be all in.

Expected Financial Capital, Human Capital, and Total Wealth over the Life Cycle

Tip of the day
If you want to maximize your investment returns and protect yourself and your family, you must learn to consider both your human capital and your financial capital while making your investment decisions.

The nature and security of your career or job (or your human capital) must decide the choices you make with your financial capital. You must know whether you are a stock or a bond.

Then, if you are a stock, make sure your savings and investments are tilted toward bonds.

On the other hand, if your job is secure and you are a bond, make sure your savings and investments tilt towards stocks.

You see, the ultimate idea for you is to factor in your unique human capital. It not just adds a new dimension to your financial plan, it also leads you to the path of sound and effective investing.

‘Are You a Stock or a Bond?’ is the name of a book written by Moshe A. Milevsky, a finance professor at York University in Toronto.