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By Christine Benz and David Blanchett | 01-22-2014 05:00 PM

When to Get Hands-On With Your 401(k) Allocation

Certain job characteristics, real estate assets, small-business ownership stakes, and pensions could require a more customized investment allocation, says Morningstar Investment Management's David Blanchett.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Joining me to discuss some special circumstances that might influence how you allocate your 401(k) plan is David Blanchett, head of retirement research for Morningstar Investment Management.

David, thank you so much for being here.

David Blanchett: Thanks for having me.

Benz: David, Morningstar Ibbotson has long done a lot of work on human capital. Let's talk about this idea of human capital and how it might influence you to make your asset allocation of your investment assets more or less conservative?

Blanchett: Let's first answer the question, what is human capital? Human capital is the value of your earnings potential. Each person who is very young, for example, may work for 30 or 40 years. There is an actual asset that person owns that is based upon your industry. If you're going to go out and make $50,000 a year for 30 years, that has a pretty big value. It's your largest asset when you're younger.

Certain types of industries move in-step with the market. For example, if you work for an energy company in Texas, you shouldn't probably hold a lot of energy stocks in your financial asset portfolio.

Benz: Also the volatility of my earning stream should affect the positioning of my assets as well?

Blanchett: Of course. Think about what would be bad to happen for an investor. Let's say that they have a portfolio of stocks--again they live in Texas--and they work for an energy company, and then all of a sudden they lose their job because the energy business went down for some reason. Then they have no more job, and their portfolio has gone down, and also possibly their house has gone down in value as well, and so all three bad things happen at the same time.

Benz: How should those characteristics of your human capital affect how you allocate your investment capital?

Blanchett: At the highest level, think about the assets you own. I don't necessarily advocate each person buying individual stocks, but if you work for a chemical company, don't invest your portfolio in chemical stocks. If you work for a bank--a bank is kind of like a large-value security--don't own as much large value. Tilt your portfolio away, if you can, from those exposures you have via your human capital to have a more diversified portfolio.

Benz: Let's talk about some other special circumstances that would influence someone's asset allocation to be a little bit different from what might be the standard prescription for someone in that age band. One example I'd had like to look at--and this is sort of ebbing away as a percentage of the population--is for people who do have pensions and also some sort of investment assets, maybe in a 401(k) plan as well. How should they think about allocating that 401(k) plan? Should it look different?

Blanchett: I think so. Pensions, like Social Security benefits for retirees, are very bond-like. If you have a lot of money, or even some money, in these investments or assets that are more conservative, you can be more aggressive in your 401(k). If you have most of your income in retirement through Social Security and pensions, you should really look to be more aggressive in your 401(k), because you can afford to be, because you have that bond-like guaranteed income through your pensions and Social Security.

Benz: How do real estate assets fit into the mix--whether you own your own home or maybe you own some rental property that you think will provide you income during retirement? How should you think about those, and should that affect your asset allocation?

Blanchett: It definitely should. Up until maybe five years ago, real estate was a very conservative asset class for most households. What we saw after 2008, real estate went down significantly.

I think real estate is interesting, because it's a levered asset in many cases. If you buy a home with 20% down, you feel 5 times the return of that house in your portfolio. So if you buy a house for $100,000, put 20% down, and then that home goes down in value by 20%, you've lost your entire equity position. So it's very volatile.

Also in many cases it's tied to your human capital. For example, I'm sure a lot of people that work in Texas work in the energy business. So if an energy business goes down in Texas, it would affect your home. The same thing for the motion picture industry in California, financial services in Washington D.C. All these different places have different unique correlations to real estate, because people that do those jobs live in those places.

Benz: How should that affect my investment positioning?

Blanchett: If you have a lot of leverage in a home, don't own REITs at all. A house … is different than commercial real estate, but there are similar factors there. The key there is just to keep that in mind. If you have a very levered house and you are worried about a volatile marketplace, maybe have a more conservative portfolio. Because if you need to potentially get out of the house, or something happens, you would have the cash position to actually pay that down, because a five times leveraged position is dangerous regardless of whether it's real estate or if it's stocks.

Benz: And the same would go if you have some sort of rental properties that you own?

Blanchett: Yes, exactly. Real estate can be a great investment. It has been over the long-term, but it's also been very volatile, especially recently.

Benz: Another thing I'd like to talk about is people who have concentrated ownership stakes in businesses. I know you would say, don't do that if you can avoid it.

Blanchett: Yes.

Benz: But for some people it's inevitable, particularly business owners. Let's talk about how they think about asset allocating their investment portfolio if they also happen to have these concentrated business instruments?

Blanchett: If you are someone who has a business that's mostly a single company--that's most of your wealth--you should look to be even more conservative with your other assets, because you need to have a cushion against volatility. Again, it's the same general theme where [you should] look to own assets that aren't correlated highly to your actual business. So, if you own a business that is in the pharmaceutical industry, don't own that in your portfolio. If you have that high concentration in one security or company, it pays to be more conservative in the rest of your portfolio.

Benz: From a practical standpoint, though, that can get difficult. The pharmaceutical industry is a really big industry here in the U.S. and globally. How do you create a portfolio where you excise that piece of the market?

Blanchett: One way is to do it is at the sector level. You could maybe own the 11 other sectors that comprise a given index, or you can work with a financial planner to have a more specific portfolio.

But I think that's a great point: The more different you are from everyone else, [the more you may] need that customized advice. If you are the average person, then you are probably going to be OK. But if you are that business owner who has a very large position in a single company, it really makes sense to understand what you should be doing with the rest of your assets and maximize your diversification.

Benz: And you say that for most people, if they stop and think about it, they probably do have some extenuating circumstances that would cause them to look a little bit different.

Blanchett: Yes. Most people do, but I think people that have the biggest differences know they are different for different reasons. Obviously it's a personal reflection, but it never hurts to stop and think, what is it about me and what I've got that makes me different, and how should it affect my overall portfolio or how I invest?

Benz: David. Thank you so much for being here.

Blanchett: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

Disclosure
The Morningstar Investment Management division is a division of Morningstar and includes Morningstar Associates, Ibbotson Associates, and Morningstar Investment Services, which are registered investment advisors and wholly owned subsidiaries of Morningstar, Inc. All investment advisory services described herein are provided by one or more of the U.S. registered investment advisor subsidiaries. The Morningstar name and logo are registered marks of Morningstar, Inc.

“The information, data, analyses, and opinions presented herein do not constitute investment advice; are provided as of the date written and solely for informational purposes only and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Past performance is not indicative and not a guarantee of future results.”

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