What constitutes a “proper” risk allocation has a certain reflexive answer to it. The general rule is take 120 – your age and this should be the percentage of your investments in equities (100 – your age for the more conservative set). However, the entire equation lacks a certain contextual perspective. As Larry McDonald highlighted recently, one of the more informative pieces I have read this year is an interview with economist Moshe Milevsky on human capital and assessing risk. His point fundamentally being is to take stock of your life, above and beyond your age, and to asset allocate and determine risk accordingly.

Ever the economist though, he tends to think of households as inputs and outputs and your compensation as “human capital” as opposed to speaking in plain English.  But his point seems to highlight something I have heard and seen lately on at least the high net worth advisory side; a certain movement away from the rule of 120 and towards a more contextual approach to asset allocation. Let me try to illustrate in real life terms.

At a recent investment seminar I attended, an audience member asked “is there ever a case for holding an all fixed income portfolio?” The advisor’s answer was that one of his clients was an equity trader. Given that his entire compensation is based on the state of the equity market, his entire portfolio was in bonds to mitigate against downside risk.

The point that the advisor was making is that your asset allocation should flow from how you are compensated first and foremost since you can’t invest if you don’t make any money but your investments should not strictly follow the same strengths and weaknesses of your income source.

To drill down one more level, let’s divided this up into real life scenarios:

Your primary source of income is secure and your retirement safe.

The fully pensioned (defined benefit pension at that), life-time guarantee of employment is rapidly become the Dodo bird of employees (public sector union beliefs notwithstanding). But while we still have this class of employees, as Milevsky points out, why isn’t  the asset allocation of this type of employee tilted towards more “riskier” ventures since employment income is basically assured and retirement benefits exist.

Your primary source of income is tied into the public markets.

As Nortel employees found, the life of an employee in a publicly traded company can be a dangerous one given: (i) the security of your job is not only vulnerable to the regular risks of holding a job but also public market risks- have a few bad quarters and the street is indirectly asking for your job to improve earnings;  and (ii) compensation such as employee stock option plans can quickly be worthless if your company/employer performs poorly. Hence, the traditional advice not to invest too heavily in your employer (one of the personal finance lessons of the Enron collapse) is really one born of proper asset allocation.

In this type of situation, the proper analysis would be to weigh more heavily than usual in lower risk, lower return investments the more your employer is a smaller publicly traded company since one’s employment is slanted towards higher risk, higher returns (raises and bonuses). Even earning “safe” employment income, the source of that income may be risky and investment choices should recognize this fact.

You are self-employed.

Income fluctuates. The good months are great. The bad months are terrible (and often cash flow negative given most owner managers have to put money in during bad months). Sounds a lot like the equity market doesn’t it?

Building a business is a boom/bust proposition. A conventional asset allocation approach may have to be amended for some lower risk investments to smooth out the fluctuations. Consideration should also be given to liquid assets at relatively the same price as purchase in the event you are required to infuse the business with capital (which is why contributing to a TFSA may be better than a RRSP for self-employed people- withdrawals are without penalty).

Given income production tends to be “riskier,” investment choices should ideally be less risky.

You live in a boom/bust region.

Geography is rarely mentioned in asset allocation but if you lived in central Alberta since the early 80′s or worked in Dubai for the last 10 years, you understand how you can be paid like a king one day and told by the king the next that he has no money (literally in the case of Dubai). If you happen to live in a boom/bust region and your employment is tied into what makes the region boom and bust, you may want to consider an asset allocation strategy that is influenced by some counter-cyclical-ness to your region’s fortunes.

Your employment is seasonal or part time.

Fish disappear. Summers can be cool. Winters can be warm. They may not call you back next season. All these factors require some adjustments to conventional asset allocation towards less risk. These types of situations may also require a lot more cash on hand as part of an asset allocation strategy.

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Age is certainly a factor in proper asset allocation and risk management. However, it should not be the only one. Individual life contexts should be the anchor of a successful asset allocation strategy.