Recently I was revisiting a very interesting parallel drawn between human capital and financial capital as they both relate to building a portfolio. In 1980, R.A. Campbell developed a framework for life insurance that involves the trade-off between risky vs. non-risky assets. The parallel when applied to how financial wealth is derived is actually pretty interesting.
Human Capital + Financial Capital = Total Financial Wealth
If the average individual will have about 40 years to monetize the value of their human capital—i.e, earn a living—and some of those earnings will be translated into financial capital (e.g. stocks, bonds or other investments), then investors should be focused on building a wealth creation plan that will maximize those two components at their peaks.
It is likely you have been told over your life about financial capital, but how well have you focused on human capital? You've probably ignored the value of human capital, or the power to earn. (For related reading, see: 6 Life Events That Call for Professional Financial Advice.)
Imagine the following is true:
If the above graph is of a typical working person earning $35,000 per year, let’s do some quick math (thanks MS Excel!):
- Over the next 40 years, with no pay raises and inflation (of 3%), cumulative earnings are $2.99 million, or
- Over the next 40 years, with 1% annual pay raises every 2 years and inflation (of 3%), cumulative earnings are $3.38 million, or
- Over the next 40 years, with 1% annual pay raises every year and inflation (of 3%), cumulative earnings are $3.85 million
So let’s just take the average of those three scenarios (assuming most Americans fall into at least one of those categories) and earn about $3.41 million dollars over a 40-year career. Realizing that represents a gross number, without taxes and living expenses, what amount of financial capital could be achieved by just taking 10% of that total human capital? (For related reading, see: 3 Financial Planning Questions for 30-Somethings.)
(Just a bit more math…)
- Saving 10% which is $341,000, is just about $327 per pay period (assuming a pay schedule of twice a month) over 40 years. Assuming the rate of return averages 7.5%, the retirement nest egg would be $2,159,566!
So why aren’t investors placing higher value on their human capital in order to create more financial wealth? Here are three reasons why I think this is not happening:
There's Too Much Focus on the Wrong Thing...
Ashvin Chhabra, chief investment officer at Merrill Lynch, says “If the markets don’t really care about you, as surely they do not, then why should you spend all your time and effort trying to beat them?” This is such a good point. In his book, he expands on a concept called the “Wealth Allocation Framework” that is much more about capital allocation across a spectrum of goals as well as asset classes. Too often, the focus is myopically on investment returns when an investment portfolio only represents a “portion” of one’s financial wealth. Other things to consider are personal use assets like your home, and the most powerful of all (at least until later in life)–human capital. (For related reading, see: Can You Stomach the Perfect Investment?)
Investing Needs to Be More Logical
I’ve seen a lot of instances where the emotions of investing take over sound reasoning. Many investors are doomed to fail at leveraging their human capital to achieve maximum financial wealth because of mistakes made during the investment cycle—so many times good discipline is overridden by irrational behavior. This is why, often times, it makes more sense to hire someone to help you make decisions.
As Carl Richards puts it, financial advisors are here to “keep you from doing something stupid.” I think this is a valid point, because human capital cannot be replaced as time passes, only financial capital can. (For related reading, see: 8 Common Biases That Impact Investing Decisions.)
Ignorance ... Maybe?
Unfortunately, this type of thinking is not widely known or discussed. I actually learned it during my master’s program at Creighton University. So although somewhat intuitive, I’d never explored this topic in any depth—and I’ve been in the industry for almost two decades! I believe the takeaway is that financial advisors have to start discussing the importance of human capital and its relation to financial wealth. They also must begin to start practicing it by considering it in client wealth allocation models. (For related reading, see: An Introduction to Asset Allocation.)
When it is all said and done, time will have passed and your power to earn will have diminished. The question will be: Did you ignore the value of human capital in your overall financial plan?