Viewpoints

December 18th, 2014 | by

Human Capital and Your Investment Portfolio

Consider the case of two investors, Fred and Amy. Fred is a commission-based stockbroker; Amy is a tenured college professor. Who more resembles a stock and who a bond?

To answer this question is to explore the concept of human capital. Human capital is one of the most valuable assets that almost any investor—especially a young accumulator who’s just entered the workforce—possesses. Yet it is an asset that many investors overlook when they build their portfolios. My aim in this column is to help you understand human capital and how to integrate the concept into your investing.

Converting Human to Financial Capital

Let’s start with a definition. We can define human capital as the present value of your future labor income, or lifetime earning power. Contrast this with financial capital, or your monetary investments. Over the course of your career, you effectively convert human capital into financial capital by saving and investing a portion of your employment income.

Thus, the young accumulator is rich in human capital but probably less so in financial capital. As she grows older, she will gradually exhaust her earning power but, assuming she’s saved and invested prudently, her financial capital will compound nicely. The exhibit below, a hypothetical but realistic scenario, illustrates this process. Note how financial capital surpasses her waning human capital when she’s in her early 50s and comes to dominate total wealth (i.e., human plus financial capital).


Stock or Bond?

Now let’s return to Fred, the broker, and Amy, the professor. Fred’s labor income correlates with equities: It is variable and volatile (like a risky asset) and tied to the economy and financial markets. Fred, all things being equal, should consider maintaining a relatively higher allocation of low-risk fixed income and holding more liquid assets, such as cash, in his portfolio. Imagine, for instance, if Fred loses his job (labor income) in a stock market crash and has most of his financial wealth tied up in stocks: He would suffer a double whammy.

Amy, like a civil servant or dentist, has good job security and a stable income. In our analogy, she resembles a bond. Since her human capital has little correlation to equity markets, all things being equal, she can invest more in stocks and take more risk in the investment portfolio. In a similar vein, if you’re young and rich in human capital, you can probably afford to take more investment risk since you have ample time to recoup investment losses and opportunities to invest labor income ahead of you during your working career. Individual situations may differ heavily from this general approach, however – age is a far less reliable guide to the appropriate level of risk in a portfolio than a detailed understanding of financial goals, needs, and objectives.

To reinforce the concept of human capital with your profession and investment portfolio, here are a couple more examples. A realtor with labor income tied to real estate cycles should probably limit real estate exposure in the portfolio and also be thoughtful about interest-rate sensitive holdings since interest rates are a key risk factor for real estate. Similarly, an entrepreneur or worker in the retail industry may want to build a diversified investment portfolio which is less sensitive to consumer spending.

Finally, I should make note of a very common and dangerous mistake I often see workers make in their retirement portfolios. Perhaps due to what in behavioral finance we call overconfidence and familiarity bias, employers and employees tend to overestimate their investment skills and overweight familiar assets within their retirement accounts. Thus, they may be heavily invested in their employer’s stock (and perhaps those of other companies listed in the industry), which raises the odds of both human and financial capital being simultaneously impaired. (Think of the employees of Enron Corp. whose retirement savings were largely tied up in their ill-fated employer’s stock). For more on behavioral finance and investing, you can also reference a book chapter I have published on the subject: Advising the Behavioral Investor: Lessons from the Real World.

Conclusion

Human capital is an important but often neglected subject in finance. Whether they’re more akin to a stock or a bond, investors can enhance the diversification and risk management aspects of their total wealth by integrating the concept of human capital into their portfolio allocation decision-making.

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