When most people think about asset classes, things like stocks, bonds, real estate and commodities come to mind. Investment advisors spend countless hours researching the risk/return profiles and correlations of these "common" asset classes, in an attempt to construct efficient investment portfolios for their clients.
However, if you are a young to middle-aged investor, the importance of these asset classes pales in comparison to an asset class called human capital. Human capital is intangible and cannot be directly purchased or sold. For this reason, it does not get much financial press. If you are between the ages of 18 and 50 (or you still act like you are), then you may be interested in what human capital can do for you in addition to how you can use it to grow and protect your financial capital.
What Is Human Capital?
If you learned about human capital in business school, it was probably defined from a business owner's perspective, but what about from an individual investor's perspective? To an individual investor, human capital is the present value of all future wages. When you are young, it is usually the most valuable asset that you own. Human capital is also your best protection against inflation. With a strong professional skill set, you will always command a fair wage, no matter how inflated your local currency becomes.
Anything you do to increase your ability to earn higher future wages could be considered investing in your human capital. The monetary and time-consuming investments that you make early in life, like obtaining a higher education, on-the-job training and learning better social skills can increase your personal human capital.
Human capital should be thought of as an asset class that should be part of every portfolio. While illiquid and non-tradable, human capital should be a key driver for the portfolio needs of an investor and should be hedged by financial capital – not the other way around.
(To learn more about investing in your human capital, read Invest in Yourself With a College Education.)
How Human Capital Affects Financial Capital
Over your lifetime, your human and financial capital should go in opposite directions. As you age, you have the opportunity to use your human capital to increase your financial capital. It is an "opportunity" because financial capital is not a given, rather it is earned through wages, savings and smart investment decisions.
During your working career, the risk characteristics of your human capital should affect how you allocate your financial capital. Factors like job stability, income volatility and the industry in which you work should all be considered when selecting an asset allocation for your financial capital.
It is also important to keep in mind that human capital’s correlation with the stock market is a key element of asset allocation and should not be overlooked when making any type of investment decision.
Below are two examples of how the risk characteristics of your human capital can affect the asset allocation of your financial capital.
Example 1 - Investing in Company Stock
A highly specialized chemical engineer working in the oil industry would not want to have a portfolio heavily weighted in the energy sector, or even his/her employer's stock. Career specialization makes human capital concentrated and risky, from an industry standpoint. As such, the engineer can compensate for this risk by investing his/her financial capital in industries and companies with little or no correlation to his/her human capital.
For example, investing more of his/her financial capital into sectors like health care or telecommunications, could offer diversification and help him/her better manage the overall risks of her investment portfolio.
(Learn more about investing in company stock in Your Employer's Stock: Should You Buy In?)
Example 2 - Income Volatility and Investment Risk
A real estate broker would face more human capital risk than a pharmacist. The real estate broker may have a higher appetite for financial risk, but his wages are more volatile, more difficult to replace and less secure than the pharmacist's. This extra risk makes the broker's income stream less valuable. All else being equal, he/she should compensate for this extra human capital risk, by owning a higher percentage of more liquid, less volatile, financial assets, relative to the pharmacist's.
Protecting Your Human Capital
Like any other asset class, there are risks associated with your human capital. The two main risks are death or disability risk and professional competency risk.
Death or Disability Risk
When you are a young adult, it is very important to protect your human capital with both life and disability insurance policies. Doing so will protect you and your family against a possible human capital shortfall, due to an untimely death or a career-halting illness. This is especially true if your expected future financial obligations are high.
As you get older, your need to hedge your human capital with insurance should decrease. Decisions regarding protecting your human capital with life and disability insurance should be made in conjunction with the overall asset allocation decisions in your investment portfolio.
(To learn more about life insurance, see Buying Life Insurance: Term Versus Permanent.)
Professional Competency Risk
Your ability to earn future wages depends heavily on your professional competency. Becoming too comfortable with your career could pose a hidden risk to your human capital. Like many other valuable assets, human capital needs to be constantly monitored. You should always have goals for life-long learning and stay current with industry trends and new technologies to protect against this risk.
The Bottom Line
To young and middle-aged investors, human capital offers inflation protection and is a very important asset that should not be overlooked. All investment decisions should take into account the characteristics of both your human and financial capital. Your human capital should be protected with insurance and always open to further investment through more education and on-the-job training. Understanding human capital assists in capturing the entirety of an investor’s unique risks, returns and constraints – characteristics that are fundamental for effective portfolio management.
Famed investor Warren Buffett once said, "The best investment you can make is always in yourself." It has never been a good idea to be on the other side of Mr. Buffett's trade.