Look at your paycheck, and imagine what it will look like next year, the year after that and maybe in 10, 20 or 30 years into the future.
Do you see bonds?
Perhaps not, but in essence, that's what you are looking at, said Roger Ibbotson, a Yale economist and founder of the research firm Ibbotson Associates Inc.
And if you start thinking of your entire work life, and all the paychecks you'll receive until retirement, as a bond, then it should make it easier to figure out what mixture of stocks and bonds is appropriate for you in your 401(k) or other retirement savings. The easy answer: When you are years away from retirement, invest heavily in stocks or stock mutual funds, and count your work life as your bond allocation.
The idea comes from a concept that is getting increasing attention from investment managers. It's been interwoven into many of the newly designed target-date funds, which invest a worker's money in stocks and bonds appropriate for their age and the date they intend to retire. Many of those funds invest almost exclusively in stocks for people in their 20s, 30s and early 40s. Then, by retirement perhaps 50 percent of the money is routed away from the risk of stocks and into the safety of bonds.
Academic papers recently have examined the idea that a person's work life is like a bond. And a person's ability to earn paycheck after paycheck is being referred to as "human capital." It is contrasted with "financial capital," or the actual money or securities that sit in a 401(k).
Ibbotson explained the concept recently at a CFA Institute seminar for money managers.
Using human terms in asset allocation should make the process easier, he said.
"During the first 25 years of your adult life, you are building on your human capital," he said.
The point is this: When you are young, you have little money sitting in your retirement account. But you have a work life ahead of you that will deliver regular paychecks. And it's relatively dependable - like bonds, which pay interest regularly.
Even if you lose a job, you can probably land another. That's in contrast to retirement, when you need dependable financial capital - or actual bonds - because you have much less human capital.
So Ibbotson, and other academics writing about this, reached the conclusion that investors in their 20s might not need to invest in any bonds whatsoever as long as they can stomach the shocks of the stock market. Instead of investing in bonds, money-market funds or stable value funds, the financial capital they have should be in stocks.
The concept relates to typical asset-allocation theory. Generally, it's considered prudent to blend various types of investments so you have safe, dependable investments with low returns and riskier ones with higher potential returns. When you are close to needing to draw on the money, the theory suggests holding more safe investments such as bonds.
When the Vanguard Group revamped its target-date funds in June to include higher allocations of stock, the designers did it with the concept of human capital in mind, said Vanguard analyst John Ameriks.
Target-date funds for people between about ages 20 and 40 invest about 90 percent of the money in stocks.
Although people of any age might wonder about the security of a particular job, they could still have a high level of human capital, Ameriks said.
For example, someone who works for an automaker might feel uncertain about that job. But an administrative assistant in a car company could work for that company or any other type of company. That person could, consequently, hold more stocks and fewer bonds than a person with a less reliable ability to garner a paycheck.
Ibbotson says the people most able to take risks in the stock market are those with jobs like teachers or tenured professors. Their jobs are secure, and not tied to the stock market, so in the interest of diversification, stocks make sense for them.
On the other hand, he said, stockbrokers depend heavily on strength of the stock market. So they should have fewer stocks and more bonds than the teachers.
However, investors cannot focus on human capital and forget about how they feel about risks.
A central part of asset allocation is to avoid taking risks that are excessive for a person's temperament.
Research by University of Cambridge professor Stephen Satchell shows that most investors would fall into a mixture of stocks and bonds that would be allocated about 72 percent in stocks.
But that might be too high for someone who will become nervous if the stock market tanks, he said.
Money managers run their clients through elaborate questionnaires to try to ascertain their appetite for risk. And it's important for investors to think seriously about what they can handle, said Leslie Kiefer, a Cambridge Associates investment consultant.
She said people will often say in questionnaires that they would feel comfortable with their portfolio dropping 25 percent a year. But, recently, when a client expressed that sentiment, she asked how he would handle it if his $50 million portfolio turned into $38 million, and didn't recover for five to 10 years. The client found the 25 percent drop unpalatable.
The recent bear market of 2000-2002 helps people be more realistic about their appetite for risk, she said.
But investors also need to realize bear markets come with some regularity.
In a study of bear markets - or drops of at least 20 percent in the stock market - the Leuthold Group found that investors should expect bear markets to hit about once every four to five years. The average decline is 37 percent, and a bear market typically lasts about 19 months.
On average, it takes about two years for investors to recover what they lost in a bear market. And there have been some - such as in 1973 and 1974 - when it took seven years to recover.
While the stock market has been strong lately, investors still have not recovered completely from the 2000-2002, 49 percent drop in the benchmark Standard & Poor's 500 index.
Because bear markets can be traumatic for investors, Ameriks said he worries about what investors in target-date funds might do in a major market downturn.
But even though investors might become nervous, research shows they rarely make changes. And in the long run, that's to the benefit of people saving for decades for retirement, so long as their investments aren't too conservative to begin with.
In a 10-year survey of participants in a college 403(b) plan, Ameriks found that three quarters of participants never changed their investments over the entire period.
The downside of that inertia is that investors also - on their own - don't rebalance. In other words, if bonds have been strong, and stocks weak, they don't move some money away from bonds and into stocks.
Making those moves is considered wise so that people continually have the right investment mix based on criteria such as their number of years to retirement.
Gail MarksJarvis writes for Tribune Media Services.