The Economic Balance Sheet

In 1968, Douglas Engelbart patented the design for the modern computer mouse. At that time, Douglas had no idea that his patent would help revolutionize the global work force, change communication, and improve computer efficiency. It was just an idea! Put yourself in the shoes of a financial adviser at that time. If you were creating Engelbart's personal balance sheet, which balance sheet would you prefer?

No. That's not going to capture potential future income.

Not quite. That patent is clearly worth something in the future.

That's right! It's pretty straightforward. If your client had a significant future asset, you'd want to include it on the individual balance sheet at the present value because it impacts asset allocation. That's the premise of the economic balance sheet. The economic balance sheet includes the typical assets and liabilities, but also __extended portfolio assets and liabilities__, which are important for asset allocation but don't appear on standard balance sheets.

For example, these extended assets for individuals can include human capital, future expected inheritances, and the present value of future consumption. For institutions, there are natural resources, future intellectual property rights, and prospective payouts for foundations. Clearly, the difference between the regular and economic balance sheets will vary between clients, but sometimes that variance can have a real impact on asset allocation. Take an individual who works in manufacturing. Since economic growth and manufacturing are tied together, what's the correlation between this individual's present value of wages and equity market risk?

No. Economic growth and equity market risk have some correlation.

That's right! Equity market risk can be correlated to an individual's wage present value, so understanding the complete economic balance sheet can help you realistically allocate assets and make proper risk adjustments. For this reason, target date funds have become increasingly popular investment tools because these funds link the asset allocation within the fund to an assumed path of the economic balance sheet.

That's not it. Equity markets don't usually go down as the economy picks up.

For example, on a young individual's balance sheet, human capital will significantly outweigh other assets and liabilities, which gives young investors more time to take risks. So the proportion of equity exposure is really high in target date funds for retirement that's a long way away. But it's a different story for an older investor. How much human capital do you think a 65-year-old individual has left?

Bingo! Target date funds assume that there's practically no human capital left, so the risk-taking exposure within target date funds that are closer to the current time period is low. That means more bond exposure as a person ages. Put another way, human capital is assumed to be roughly 30% equity like and 70% bond like, so as human capital decreases and financial capital increases, your goal is to keep the asset allocation ratios the same over time. So financial accounts outside of human capital will shift from equities to bonds as the individual ages.

Not so. Human capital is the present value of wages, not retirement income.

Realistically, no. That might be the case in some situations, but it's not the assumed exposure.

To sum it up: [[summary]]

Standard accounting balance sheet

Balance sheet with conventional assets and liabilities

Balance sheet with all current and future assets and liabilities at present value

Near 0

Closer to 1

Closer to -1

Practically zero

Lots through retirement income

Some through potentially working a second job

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