No Portfolio is an Island: Morningstar Research Examines How Job, Home Location, and Pension Affect Optimal Asset Allocation

CHICAGO, April 21, 2014 /PRNewswire/ -- Morningstar Investment Management, a unit of Morningstar, Inc. (NASDAQ: MORN), today published a new research paper, "No Portfolio is an Island," which examines how job, home location, and pension benefits, such as Social Security, affect an investor's optimal asset allocation. This paper is an extension of Morningstar Investment Management's research and patented methodology for incorporating non-financial assets like human capital—an individual's future potential savings—into the optimal asset allocation process. This paper brings a more nuanced perspective to individual investors' unique circumstances and lays out a framework for creating even more personalized portfolios. Two Morningstar Investment Management researchers, David Blanchett, head of retirement research, and Philip Straehl, senior research consultant and portfolio manager, co-authored the paper.

"Financial assets, such as stocks and bonds, are only one component of an investor's total economic worth. Other assets, such as human capital, real estate, and pensions, often represent a significant portion of an investor's total wealth, but are not frequently considered when building portfolios despite the fact that they share common risks with financial assets," Blanchett said.   

In the paper, the researchers demonstrate that industry-specific human capital, region-specific housing wealth, and pensions have statistically significant exposures to certain asset classes and risk factors, and investors should consider them when building portfolios. Through a series of optimizations, the Morningstar Investment Management researchers compare the asset allocation differences between portfolios that are only optimized for financial assets versus portfolios that consider total wealth. They determine that the optimal allocation varies materially when vocation, location, and pension benefits are considered, with average asset class differences exceeding 20 percent.

Other findings include:

• Given the bond-like nature of human capital, portfolios that incorporate this asset generally tend to have lower allocations to intermediate- and long-term bonds and higher allocations to large-growth U.S. equities and commodities.
• Investors who work in the manufacturing, utilities, and government sectors saw the largest changes to their optimal portfolios after the researchers factored industry-specific human capital into the asset allocation optimization. Their total-wealth optimized portfolios were significantly more aggressive than average, largely due to lower human capital volatility in these professions.
• Housing wealth has less effect on the optimal asset allocation than industry-specific human capital, but still plays an important role. Of the 10 cities studied, home owners in Las Vegas had the largest changes to their optimal portfolios after the researchers factored regional-specific housing wealth into the portfolio. Their total-wealth optimized portfolios were generally more conservative than average given the historically volatile Las Vegas housing market, and had larger allocations to high-yield and non-U.S. bonds as well as small-cap value equities.
• Because industry-specific human capital has such a significant effect on the optimal portfolio, younger investors who naturally have higher levels of human capital saw larger changes to their portfolios than older investors when total wealth was considered in the optimization.

"Each investor's situation is unique and his or her financial portfolio should reflect those distinct risk factors. The Morningstar research shows, for example, that if you're a banker in Texas, your human capital and real estate wealth are tied to the financial and energy sectors as well as to large-cap value stocks, so you would want to reduce exposure to those asset classes in your financial portfolio," Straehl said. "Our findings have important implications for individual and custom target-date model portfolio construction, and suggest that techniques that ignore human capital and outside assets are insufficient. A holistic definition of wealth is necessary to build truly efficient portfolios."

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About Morningstar Investment Management
The Morningstar Investment Management unit creates custom investment solutions that combine award-winning research and global resources with the proprietary data of Morningstar, Inc. Morningstar Investment Management includes 11 investment advisory entities around the world that provide comprehensive retirement, investment advisory, and portfolio management services for financial institutions, plan sponsors, and advisors. As of Dec. 31, 2013, Morningstar's investment advisory subsidiaries had approximately $159 billion in assets under advisement and management, including about $11 billion in solutions such as custom target-date model portfolios.

About Morningstar, Inc.
Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offers an extensive line of products and services for individual investors, financial advisors, asset managers, and retirement plan providers and sponsors. Morningstar provides data on approximately 446,000 investment offerings, including stocks, mutual funds, and similar vehicles, along with real-time global market data on more than 10 million equities, indexes, futures, options, commodities, and precious metals, in addition to foreign exchange and Treasury markets. Morningstar also offers investment management services through its registered investment advisor subsidiaries. The company has operations in 27 countries.

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SOURCE Morningstar, Inc.