Human Capital and Your Portfolio

Categories: Getting Help
creative commons image from flickr user Jon_Tucker

Are you more like a stock or a bond? Chances are this question has never occurred to you. But it’s one you’ll need to answer when you use the concept of human capital to diversify and build your wealth.

Wealth Comes in Two Forms

Let me start by introducing the concept of human capital, an intangible asset, as it applies in financial theory. You can think of your total wealth as being composed of two parts: human capital and financial capital.

Human capital is commonly defined as the present value of your projected labor income for your working years.1 In other words, it’s a measure of your future earning power. Over the course of your career, you essentially convert human capital to financial capital by saving and investing a portion of your employment income.

Typically, the value of your human capital peaks the day you start your career because all your years of earning labor income are ahead of you. In contrast, your financial capital is probably lowest at this stage because you haven’t yet had a chance to save and invest.

As you grow older, you will gradually exhaust your earning power, so the value of your human capital will wane. But assuming you’ve prudently saved, invested, and compounded your labor income, your financial capital will steadily increase. At some juncture in the middle of your career—perhaps when you’re in your 50s—the value of the rising financial capital will exceed that of the declining human capital.

The Case of the Accumulator

Now that you understand the concept of human capital, let’s look at how you can integrate it into your portfolio allocation.

Here’s one simple example. If you are young and recently started working, you’re in the “accumulation” phase of your investing life. When you’re an accumulator, you typically invest most of your long-term capital (e.g., 401(k) or IRA contributions) in “risky assets,” such as stocks, and relatively little in less volatile assets with lower expected returns, such as bonds.

In a human capital framework, young investors whose total wealth is dominated by human capital are able to take more investment risk than older investors because they have more time to recoup investment losses and can invest more labor income over a longer time horizon. Because as you age your human capital dwindles and your financial capital mounts, you’ll probably want to shift gradually to a more conservative portfolio.

Bond or Stock?

So, are you a bond or a stock? The answer to this question depends on the risk profile of your profession and is a factor that may affect your appropriate portfolio allocation. In short, a risky job is more “equity-like”; a safe job more closely resembles a risk-free bond. For instance, if your income varies from year to year—say, because you have a bonus- or commission-based job—or it’s highly correlated with the stock market, then we can say that your human capital is “stock-like.” In this case, all things being equal, you may want to consider maintaining a relatively higher allocation of low-risk fixed-income investments and holding more liquid assets, such as cash, in your financial portfolio.

Alternatively, if you’re, for example, a tenured professor, civil servant, or dentist, then your labor income is probably more stable. In this scenario, your human capital is more “bond-like,” so all things being equal, you can invest more in stocks and take more risk in your investment portfolio. In other words, to balance and diversify human capital, a stockbroker should invest less in the stock market than a tenured professor.

Your Job and Portfolio

So, take the risk and return characteristics of your employment into account when investing in financial assets. Because we’re seeking total wealth diversification and risk control, one implication is to avoid investing heavily in your employer’s stock. You don’t want to end up like the employees of Enron Corporation who had the bulk of their retirement savings tied up in their ill-fated employer’s stock.

If your employer goes out of business, you don’t want to be hit by your human and financial capital being simultaneously devastated.

As you allocate personal assets, you’re quite likely better off underweighting investments that are closely correlated with your employer’s stock and line of business and tilting toward better diversifiers.

For example, if you work for a market newsletter—a business that is vulnerable to volatile stock market cycles—you should consider a higher weighting in bonds and a below-market-weight allocation to financial sector stocks. If you’re in the real estate business, then consider underweighting property stocks. If you work for a technology company, then you may want to underweight tech in your portfolio and perhaps tilt a bit toward consumer stocks.

Conclusion

Human capital is an important but often overlooked subject in finance. Whether you’re more like a bond or a stock, you can improve the diversification and risk management of your total wealth by integrating the concept of human capital into your portfolio allocation decisions.

If you liked this post, don’t forget to subscribe to Inside Investing via Email or RSS.

1See, for example, Roger G. Ibbotson, Moshe A. Milevsky, Peng Chen, and Kevin X. Zhu, Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance (Charlottesville, VA: Research Foundation of CFA Institute, 2007).

IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Gerstein Fisher), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  All references to market performance were obtained from Bloomberg database. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Gerstein Fisher.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Gerstein Fisher is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of Gerstein Fisher’s current written disclosure statement discussing our advisory services and fees is available for review upon request.

Tags:

Leave a comment

Your email address will not be published. Required fields are marked *