Time, wealth, and human capital as determinants of asset allocation

Abstract This paper provides a theoretical model for individuals to make asset allocation decisions based on their value of leisure time, risk tolerance, and a retirement goal. As individuals go through life cycles financial wealth increases while human capital and time decrease. A critical point is identified where individuals maximize leisure time and financial wealth. The model suggests basing asset allocation decisions on the level of wealth in relationship to the retirement goal and time, rather than the age of the individual typically used in investment planning. © 2004 Academy of Financial Services. All rights reserved. JEL classification: G11; D12; J26 Keywords: Total wealth portfolio; Asset allocation; Time horizon; Retirement accounts; Life-cycle hypothesis "Dost thou love life? Then do not squander time, for that is the stuff life is made of". . . Benjamin Franklin 1. Introduction This paper presents an individual life cycle model for use in the asset allocation decision process. The model assumes that individuals reach a critical point in their life where they desire to maximize leisure time as well as wealth. The model presented in this paper extends the theoretical model of Bodie et al., (1992) and empirical work of Van Eaton and Conover (2002) by illustrating how time impacts portfolio and consumption choices over an individual's life cycle. An individual's total wealth is comprised of human capital and financial wealth. Total wealth at the start of an individual's life cycle is comprised almost entirely of human capital, which is defined as the present value of all future earnings. With the passing of time, individuals' total remaining human capital decreases while their financial wealth increases. As individuals approach retirement they rely more on financial wealth and less on human capital to achieve a retirement goal necessary to maintain a desired standard of living. Time is an important determinate of an individual's total wealth. Increasing the amount of time devoted to labor hours increases human capital that in turn increases total wealth. In addition, increasing the amount of time devoted to labor hours, delays consumption from savings, thus, allowing savings to continue to compound and accumulate. A major constraining factor for individuals is their limited amount of time allotted to them. Do individuals live for the enjoyment of accumulating wealth or do individuals accumulate wealth so that they can enjoy leisure time? If individuals live to accumulate wealth, why do they retire? A plausible reason for retirement is related to the fact that individuals value leisure time. Individuals must choose how to allocate their time between labor hours and leisure time. Individuals, who value leisure time, maximize leisure time as well as wealth. Traditional financial planning models suggest an asset allocation strategy that focuses primarily on the age of the individual. This strategy emphasizes the maximization of retirement wealth and ignores the importance of leisure time for individuals. An appropriate asset allocation strategy should consider all relevant factors for the individual, including the value of leisure time. In this paper, a critical point is identified where the individual's wealth comprised of financial investments is equal to total remaining human capital. This is a very important turning point in the individual's life because the expected return from financial wealth begins to contribute more to current and future consumption needs than human capital. section 2 provides a discussion of the issues of time horizon, time diversification, shortfall risk, and the life cycle model as a determinate for asset allocation. A life cycle model is defined in section 3 illustrating the tradeoffs between human capital, time, and financial wealth. An important implication of the model suggests that individuals who desire to maximize both leisure time and wealth should focus on critical wealth levels as well as time horizons. …