Human Capital and Behavioral Biases: Why Investors
Don’t Diversify Enough

Abstract

An often-ignored component of an individual’s wealth, but one that can dominate one’s portfolio, is human capital. More often than not, individuals don’t take their biggest asset—human capital—into account when making portfolio decisions. In fact, quite often, individuals fail to recognize that human capital is even a part of their overall portfolio, instead focusing simply on financial assets and real estate.

Many wealth managers neglect to consider the enormous impact of human capital on wealth management decisions for their clients, and the consequences become most evident during economic downturns. We posit that behavioral biases play a major role in the poor choices individuals make with respect to portfolio decisions related to human capital, particularly in the decision on how to invest their retirement assets—oftentimes choosing to concentrate their holdings in their own company stock.

We believe that the failure to take human capital into account when making individual investment decisions can be explained to a large extent by emotional and cognitive biases that have been identified by behavioral economists. In essence, certain types of decisions and problems may simply be too complex for individuals to master on their own. This is where the wealth manager can provide value to clients. By recognizing the importance of human capital and having a dispassionate understanding of their clients’ biases toward it, wealth managers can suggest effective measures to address the issue.

TOPICS: Wealth management, in portfolio management