Human Capital as A Long-Term Hedge?

A Long Runway till Retirement

In his new article in Wall Street Journal titled, “What You Should Do About the Stock Market’s Giant Problem”, Jason Zweig talks about the relationship between human capital and financial capital. According to Zweig, people in their young adulthood, viz., 20s, 30s, and 40s, have a runway that is decades long, meaning they have human capital that can withstand and bear a higher risk in their financial capital or portfolio. On the contrary, people in their near retirement-hood, those in their 50s, 60s, and 70s, do not have that long of a runway to bear a higher risk in the financial portfolio; hence, their human capital is close to non-existent. He ends his article by acknowledging that an all-stock portfolio when one is young does indeed make sense since the young gets a time arbitrage compared to the old.

But let’s think. Is it reasonable for a young man to think that the remaining life until retirement or death warrants as a hedge against overvaluation in his financial portfolio?

The intuitive response, or I should say the initial reactive response, was I don’t think so. This is equivalent to saying that it is okay to hold highly overvalued stocks simply because you are young. It is certainly true that the younger generation has significantly more time available to them to make up their loss when their stocks turn out to be losers. But solely having more time to make up for the loss does not guarantee future success. A person going through a loss after a loss after a loss is certainly a possibility. The normal retail investors have very close to no idea about intrinsic value of a security that they are buying into. From my personal experience, many tends to go with the crowd. Whatever is currently hot is where they end up putting their hard-earned money in. There is no reliable research done on analyzing the intrinsic value. The harsh fact is that the stocks that they buy can lose value over time, sometimes gradually or suddenly. It can lose some of its value or all of its value. After a while, the retail investors will then have to face this harsh reality. What is important to consider here is not just the first loss that they experience. It’s the future potential losses after the first loss.

A loss does not guarantee that the next security purchase will be a winner. A loss can be followed by another loss, and another loss, and another loss. So, buying an overvalued hot issue in the financial market carries an inherent risk of a considerable loss of value that could potentially wipe out the security holders’ nest egg. I think you know where I am getting at now. Human capital itself cannot be an effective long-term hedge against future losses from buying overvalued securities.

If this is indeed the case for the general public, what should one do with their money?

VOO and Chill

It is not so uncommon to find people not investing in stocks these days. I, myself, was one of those people who first got into stocks when the Robinhood app was released. Buying  pieces of the ownership of a business has never been easier. With this trend of easy accessibility to trading financial securities, a whole shabang of financial products has come out as well. ETF, or exchange traded fund, is one of them.

The general public loves ETFs. ETFs provide minimum oversight from the standpoint of the security holder and minimum expenses (relative to trading individual securities). Index ETFs, for example, hold shares of tens or hundreds of publicly traded companies and are bundled into one tradeable security. From my own small circle of friends and families, S&P 500 and NASDAQ-100 are the two most popular indices. These two consist of the most popular and largest publicly traded companies. Big names like Tesla, Nvidia, Microsoft, Netflix are in them. The ETFs that track these indices have been performing extraordinarily well over the past few years and have also been returning fairly well over the past few decades. I think this is primarily because of the regular rebalancing of the companies within the index based on the “rebalancing criteria”.

The rebalancing criteria involves many conditions, but the most notable ones are the market capitalization size, trading volume (liquidity), and recent positive earnings. Among the thousands and thousands of companies out there, only the top 500 (for the S&P 500) make the cut and get rebalanced every quarter. Some companies who don’t meet the criteria get kicked out, and those who meet it get to enter into the ‘500 club’. So, generally speaking, the biggest 500 companies that are traded frequently (liquid), big enough size (market cap), and have produced short-term positive earnings (financial viability) stay in the index. One example is VOO, an ETF that tracks the S&P 500 and is managed by Vanguard.

For the general public who do not have the time to do a deep dive into individual companies’ past records and future prospects, buying VOO and forgetting about it might be the best possible solution to grow their hard-earned money over the long term. Although VOO is heavily concentrated with overvalued tech stocks, the index is systematically rebalanced on a regular basis. Prolonged losses in the stock price will get the stock kicked out of the 500 club, replaced by an emerging contender. Therefore, such a strategy – aka VOO and Chill – might be a better option for the norm to grow their money over the long term than buying individual overvalued stocks and holding them.

A Paradox

Although I have concluded that a large human capital backed by a long-term horizon until retirement does not vindicate buying overvalued stock because of its inherent risk of significant near-term losses, it is important to recognize that this conclusion involves a paradox.

VOO in and of itself is heavily concentrated in highly overvalued stocks – mainly the M7. Buying VOO becomes equivalent to buying a handful of overvalued stocks. Therefore, my suggestion to “VOO and Chill” may appear to be conflicting with what I have mentioned earlier about avoiding hot, overvalued issues.

My argument that a large human capital cannot be an effective long-term hedge against future financial trough still holds. My objection is directed towards buying individual hot issue and holding it while justifying it with the idea that one has enough time to recover from potential significant losses if things go south. If one has the will and time to delve deep into analyzing a business, purchasing an individual financial security can be justified as an “investment” in the Benjamin Graham sense. Otherwise, following the herd is a pure speculation – if not outright gambling.

Because it is so very important for one to protect his assets (by and large against inflation among other things), no matter how small or large they are, I believe holding some form of financial security that has the potential to appreciate in value over time is a must. Although VOO is indeed packed with a few hot stocks, because the index is systematically rebalanced with set criteria that weigh the short-term market force (or momentum), the risk of considerable long-term loss in value is relatively reduced as it is validated by the index’s historical return. VOO in its nature is liquid, so buying and holding it for a long term may be a viable option for the general public to be hedged against inflation and even to grow money above inflation over time.