Your Job Should Drive Your Savings Plan

How should I invest my savings long term? The question has become almost a national obsession over the past three decades as defined contribution plans—401(k)s, 403(b)s, 457s, the various IRAs—have become the mainstay pension for American workers and families.

We're not just talking about retirement savings. There are also 529 college-savings plans, health savings accounts, and mutual fund and exchange-traded fund investments. Whatever their savings goal, millions of Americans sometime during the year sit at their desk or kitchen table, turn on a computer and look through a stack of investment guides to make sure they're on the right track.

Investing long term seems pretty straightforward. Stocks are riskier than bonds, which in turn are more volatile than cash. The reward for taking greater risk is the opportunity to earn a greater return. Stocks have had an average rate of return of 9.8% since 1926, according to Ibbotson Associates, a Morningstar company. Bonds had only a 5.6% return over the same time period. So, go with stocks, right? Not so fast. Bonds have crushed stocks in the performance department over the past ten years—7.8% for bonds versus 2.7% for stocks. Now what?

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We’ve all learned the hard way that there’s nothing straightforward about deciding where to invest your money. Will the stock market crater if the European debt crisis spirals out of control? Can the U.S. regain its economic dynamism in the coming decade? Is deflation the new price trend, or is a vicious inflationary spiral on its way?

The uncertainty is excruciating, yet how you allocate your money among the different investment choices could make the difference between counting your pennies and taking your grandkids on annual vacations years from now.

The uncertainty may be unavoidable, but you can come to a more rational decision by starting from a different place than market history and investing insight. Turn off the computer. Put down the performance charts. Forget about your financial assets (for the moment). Instead, put up your feet and think about your education, your job, your career—what economists call your “human capital.”

Here’s how Nobel laureate and University of Chicago economist Gary Becker defines human capital: “Wealth in the form of human capital consists of present and future earnings because of education, training, knowledge, skills, and health.” The money most people earn during their career dwarfs their investment assets. The same is true for the economy. Becker and other economists estimate the value of America’s human capital is at least three to four times the value of stocks, bonds, homes and all other physical assets. It truly is the wealth of the nation.

Are You a Stock or a Bond?

In practice, a human-capital perspective means thinking about your income and, more importantly, its reliability. Does your income fluctuate a lot or is it fairly stable? Put another way: “Are you a stock or a bond?” says Moshe Milevsky, professor at York University and author of the book Are You a Stock or a Bond? “Look at what you do for a living and build a portfolio around that.”

The riskiness or security of your income should strongly influence your investment choices. Take the extreme example of a tenured university professor. She has incredible job security and, therefore, her paycheck is essentially a bond. (And with average yearly wage increases of, say, 3 percent, it’s much like an inflation-adjusted bond.) She can afford to invest more of her money in riskier assets, such as stocks. The same goes for government workers, K-12 schoolteachers, utility employees and the like. The more bond-like your income, the more you can afford to diversify into stocks.

In sharp contrast, the income of a contract project manager can fluctuate considerably over the years. He should invest a greater percentage of his longer-term savings in less risky assets—such as bonds and cash—to offset his income volatility. The calculation is similar for other income-insecure jobs, such as freelancers, construction workers and anyone paid on commission.

A human-capital perspective offers additional insight for constructing a portfolio. For instance, let’s say your job security is tightly linked to the ups and downs of the stock market. You’ll want to create a more conservative portfolio. Perhaps you have a set of skills that are in great demand even if there’s tremendous upheaval in your chosen profession. Well, you can afford to place a larger percentage of your savings in the stock market.

Young people with lots of human capital and few financial assets will do well to invest more of their savings in stocks. They have a lot of earning power ahead of them, which isn’t the case for aging workers with diminishing human capital.

Manage Your Uncertainty

Most of us have a better grasp of the risks and rewards embedded in our job and career choices than we have about the possible trajectory of stock and bond returns. But that’s not to say that assessing human capital is easy. Life throws us all a curveball now and then.

Say you your finances are decimated after a divorce. Or your earnings are a fraction of what you expected when you started your career because technological change caused upheaval in your industry. Or maybe your career once burned bright, but unanticipated health problems intervened.

Despite its limitations, a human-capital framework offers a richer investment orientation than the standard market-centric fare. Focusing on job prospects, the potential arc of your career and educational attainment may not go far enough. But it’s a critical step in the right direction.

When it comes to personal finances, the only thing we can be certain about is uncertainty. The way to deal with it is to delve deeply into what you really want out of life: What do you truly value, and where do your passions lie? “Managing uncertainty is really about managing yourself,” says Ross Levin, certified financial planner and head of Accredited Investors Inc., in Edina, Minn. “If you can discover what you want out of life—the why—then there are a number of ways to get there—the how.”