For decades, investors have been told to balance risk with a simple formula: the 60/40 split between stocks and bonds. New research from Yale argues that approach is fundamentally flawed, leaving many savers too conservatively positioned to maximise long-term wealth.
The research reframes how risk should be measured, arguing that most investors ignore their largest asset: future income. Wages and retirement benefits, when viewed over a lifetime, function like a stable fixed-income holding, said James J. Choi, professor of finance at Yale.
“Your income is an enormous fixed-income position, which allows you to take much more risk than many traditional methods for asset allocation suggest,” Choi told Investment Officer. If future wages and retirement benefits are taken into account, households can afford to allocate a larger share of their financial portfolios to equities, he said.
“If you have a lot of future wages and retirement benefits coming to you relative to your current financial wealth, then you can afford to take more risks,” he said, adding that it is the ratio between human capital and financial assets that matters most.
If true, the implications for asset managers, financial advisers and the broader advisory industry are considerable. The research suggests that target-date funds, model portfolios and rules of thumb widely used across the retail and institutional advisory space are steering a large proportion of clients - particularly younger and middle-income investors - into portfolios that are too conservative, potentially at a meaningful cost to long-term wealth accumulation.
“Taking risks with your 100,000 dollar financial portfolio is less dangerous if you have 1 million dollars of future wages and Social Security payments coming that will cushion investment losses.”
James J. Choi, Yale University
Salary is a bond
The core of the argument is that future wages and retirement benefits, when viewed across a working lifetime, behave much like a bond. Because labor income fluctuations have virtually no correlation with stock market returns for the average household, those future paychecks represent a large, stable, bond-like asset sitting off the conventional balance sheet.
Another important factor that drives the result is how correlated shocks to your labor income growth are with the stock market’s return. The more positively correlated they are, the more your human capital is like an investment in the stock market, and the less human capital will increase your optimal financial portfolio risk-taking.
“This correlation is close to zero in the U.S., which is why for most U.S. households, human capital acts like a bond. Evidence suggests that this correlation is also close to zero for European households, so human capital also acts like a bond for Europeans,” said Choi. Different tax regimes have no influence on the allocation mix either. “Taxes don’t play an important role in the logic for why human capital increases the optimal aggressiveness of one’s financial portfolio,” he said.
Investors who account for this implicit fixed-income position should, in most cases, hold a substantially higher proportion of their investable financial wealth in equities to achieve a truly balanced overall risk profile.
“Taking risks with your 100,000 dollar financial portfolio is less dangerous if you have 1 million dollars of future wages and Social Security payments coming that will cushion investment losses,” Choi said.
A spreadsheet that replaces rules of thumb
To make his mathematical model accessible, Choi developed an interactive spreadsheet that calculates an investor’s optimal equity allocation from five inputs: age and household income, expected future earnings and retirement benefits, total investable net worth, a risk aversion score on a scale from one to ten, and assumptions about long-term real stock market returns and risk-free interest rates. The tool updates dynamically, allowing advisers and investors to recalculate as circumstances change.
The output frequently diverges sharply from conventional guidelines. A 25-year-old earning 70,000 dollars annually after tax with 25,000 dollars invested receives a recommendation of 100 percent equities. Much more than the 75 percent under the “100 minus age” rule and roughly 91 percent in a typical 2065 target-date fund. The difference reflects the fact that the overwhelming majority of that young worker’s lifetime financial resources have yet to be earned and remain in the form of human capital.
For a middle-aged couple in their mid-40s with combined income between 80,000 dollars and 100,000 dollars and 500,000 dollars in investable assets, the formula suggests allocating approximately 89 percent of the portfolio to a diversified stock index, well above the 50 percent that a standard age-based rule would recommend and significantly above the 76 percent held by a typical 2040 target-date fund.
The model’s conservatism kicks in as financial wealth grows. The same couple with 800,000 dollars invested receives a much lower equity recommendation of 53 percent, because the larger financial portfolio now represents a greater share of total lifetime resources. Human capital is still present, but its cushioning effect is proportionally smaller.
Saving more matters most
Despite the precision of the formula, Choi is careful to keep it in perspective. The amount an investor saves, he notes, generally matters more to long-term financial well-being than how those savings are allocated. The researchers calculate that following their formula results in a welfare loss of just 0.06 percent of lifetime consumption compared with a theoretically perfect portfolio. The “100 minus age” rule produces a 2 percent loss, while a static 60 percent equity allocation generates a 3.75 percent loss.
The framework has drawn cautious praise from other academics. Vicki Bogan, a professor at Duke University’s Sanford School of Public Policy, described it as a useful bridge between academic theory and practical investor needs. “It might not be perfect, but it gives a solid, directionally correct way to think about your portfolio choice,” told the Wall Street Journal.
Others urge caution. Terrance Odean, a finance professor at UC Berkeley’s Haas School of Business, flags the inherent uncertainty involved in forecasting future income and long-term market returns, two inputs on which the model’s output depends heavily. Small changes in assumptions can produce meaningfully different allocations.