New Money Rules for Financial Security - #3. Earning Potential

[This post is written and copyrighted by FIRE Finance (http://firefinance.blogspot.com).]

When we began disciplined investing through a diversified portfolio, "experts" were of the opinion that the more years one had to recoup losses, the more aggressive one could be. In other words the younger we were the more risk we could take on. Unfortunately we learnt that the rules of money are not so clear cut.

Rule #3: Earning Potential

Old thinking: The longer your time horizon, the more stocks you should own.

New rule: Time isn't everything. You must also consider your earnings potential.

Our take: In the last six years we moved four times and changed jobs twice. Since we were young (half a dozen years ago), and in relatively stable as well as high paying careers, we took the expert advice of investing for the long run in an aggressive mode. After all we had all these years ahead of us to make up for any losses.

Well, half our portfolio and years of savings disappeared just like that when the market tanked in 2008. Unable to stomach any more risk we reallocated our portfolio towards less risk via inflation protected bonds and fixed return investments. To make matters worse, we were laid off which cut off our stable inflow of cash.

On hindsight we wish that we knew about this new money rule of considering our earning potential and its stability while designing our portfolio. Present times are teaching us that no career is high paying or stable forever. We need to adapt to new cash cows and skills with changing times. In that light, capital preservation (a good percentage) should be on our agenda right from the start. This will give a person some bandwidth to create fresh cash inflows according to new necessities.

As you age, the value of your human capital declines, and you'll need to secure more of your savings. So the conventional advice to hold a lot in stocks when you are young and gradually trim back can still make sense.

But not for everyone. The nature of your career may make your human capital more bond-like or more stock-like, says finance professor Moshe Milevsky of York University in Toronto. Tenured professors like Milevsky have human capital that resembles a triple-A-rated bond, especially when they have a solid pension plan. Those lucky souls can dive aggressively into stocks and even stay there as they approach retirement, he says. The human capital of a commission-based mortgage broker, on the other hand, is pretty clearly a stock - and it's not a blue chip. That person should own a fair amount of bonds, even when young.

It is extremely important to assess our human capital and keep some room for adapting it to new careers for creating incomes. Also, keep in view the effect of our careers on our health. If our career is extremely demanding on our health and we have a short shelf life, then capital preservation of our portfolios should be high on the agenda right from the beginning.

A recession brings on new challenges every day. In such times, human capital is one of the most volatile assets in our portfolios. So we do need to learn how to balance our portfolio with this new asset of human capital aka our earning potential.

Question

What are your views and experiences about this idea of adding your earning potential to your portfolio with respect to keeping your financial security intact in the immediate present? We are looking forward towards your feedback.

Series

New Money Rules for Financial Security
» Rule #1 - Handling Risk
» Rule #2 - Building Cash Savings
» Rule #3 - Earning Potential
» Rule #4 - Handling Debt
» Rule #5 - Home Equity
» Rule #6 - Diversification
» Rule #7 - Retirement

Image Source(s): iStockPhoto

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