Human Capital and Your Portfolio
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. See, for example, Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance. 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.
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Thank you for this article Gregg!
I’ve been thinking about human capital in terms of being its own portfolio (of skills, knowledge, network, influence, creativity, etc). Each of these “assets” may or may not be at their optimal allocation to maximize an individual’s earnings. Suppose I have great technical skills, but a poor personal network, so I am not easily able to get my marketable skills to the top bidder. I have seen myself and others invest more time and energy in areas where we are already heavily invested, thinking that a Master’s or a PhD will be the key to multiplying my earnings potential, when in reality, there is another factor that may be the greater multiplier. Can portfolio theory be applied to an individual’s human capital? I am working on this idea to identify measurable factors. I’d like to use the analogy in my role as a corporate trainer and business coach.
Cheers!
Joseph