Our total wealth includes both financial and human capital, which is the value of our future employment earnings. How to consider both in your asset allocation.
In this episode you’ll learn:
- What is human capital.
- How human capital gets converted into financial capital.
- What is habitat utility.
- How do you factor human capital into your asset allocation.
- How insurance helps hedge human capital.
How Wealthy Are You?
I recently received an email from George who is in his second year of law school. He studied accounting and finance as an undergraduate with an emphasis on real estate.
He likes to invest and even helped manage a portion of his college’s endowment as a member of a student-run investment center.
George expressed frustration that he wants to invest, but in his current stage of life he has little financial capital to do so.
George doesn’t feel very wealthy, but the reality is he is incredibly wealthy.
It’s just that most of his wealth is in the form of human capital not financial capital.
Human capital represents the discounted value (i.e. the value in today’s dollars) of all your future earnings from work.
The value in today’s dollars of George’s future earnings as an attorney could be in the millions if he plans on practicing law for thirty years or more.
By investing in a law degree, George will hopefully increase his future earnings power. In other words, he is making an investment in education that will ideally enhance his human capital, and thus his overall wealth.
Converting Human Capital to Financial Capital
As George enters the workforce, he will convert some of his human capital into financial capital as he saves and invests a portion of his annual salary.
Younger workers have a great deal of human capital and very little financial capital.
Retirees and near-retirees have smaller amounts of human capital as they have fewer years of full time employment.
Ideally, these retirees and near-retirees have been diligent over the years in converting much of their human capital into financial capital.
If not, they will need to increase the value of their human capital by planning on working full or part time well into their retirement years.
Are You A Stock Or Bond?
Just as financial assets, such as stocks and bonds, have different levels of risk as measured by the variability or volatility of returns, different employment situations can be more or less risky as measured by the variability of earnings.
Tenured university professors have little expected variability in their future earnings power. They are unlikely to be fired. Their human capital is like a short-term government bond—sure and steady.
Conversely, commission-based mutual fund wholesalers who market investment products to financial brokers and advisors can have high levels of expected variability in their employment earnings.
Individuals in this profession risk being let go during a severe stock market downturn if their employers want to reduce costs.
The wholesaler’s human capital is more stock-like given the potential for highly variable earnings, and given the risk of being laid off is higher when the stock market experiences a downturn.
Diversification With Human Capital
How should university professors invest their financial capital compared to mutual fund wholesalers?
University professors with their bond-like human capital can afford to take greater financial risk by allocating more to stocks than mutual fund wholesalers whose human capital is more stock-like.
Diversification goes beyond just allocating financial capital.
Individuals should consider the stock-like or bond-like qualities of their human capital to help determine how much risk to take in their financial portfolio.
Individuals should also consider the composition of their total wealth in determining how to allocate their financial capital.
Younger workers with their significantly higher balances of human capital compared to their financial capital can afford to have a higher allocation to stocks compared to older workers whose livelihood is much more dependent on their financial capital and whose retirement plans could be thwarted if a catastrophic stock market sell-off occurs.
Hedging Human Capital
While stock market sell-offs can impair financial capital, early death or disability can impair human capital.
Life and disability insurance allow individuals to hedge or protect the value of their human capital from disability and death.
As individuals convert more of their human capital to financial capital through savings and investment, the level of life insurance they need to protect against human capital impairment is lower.
We typically think of wealth as only our financial wealth. True wealth is much broader. It includes our financial capital and our human capital.
True wealth also includes intangibles such as our freedom, our time and our relationships with family, friends and our community.
Most of us are truly wealthy by that broader definition, and for that we should be grateful this holiday season.