When most people think about asset classes, they tend to think about things like stocks, bonds, real estate, and commodities. 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.
But if you're 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 can't be purchased or sold directly. 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.
- To investors, human capital is the present value of all future wages.
- You can increase your human capital by continuing your education or going for on-the-job-training.
- Human capital should be a key driver for the portfolio needs of an investor and should be hedged by financial capital.
- Consider job stability, income volatility, and the industry in which you work when selecting an asset allocation for your financial capital.
Human Capital for Investors
If you learned about human capital in business school, it was probably defined from a business owner's perspective. But it doesn't necessarily mean the same thing for investors. So how do they define human capital?
To an individual investor, human capital is the present value of all future wages. When you are young, it's probably the most valuable asset 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 you make early in life, like getting a higher education, doing on-the-job training, and learning better social skills can increase your personal human capital.
Human capital should be considered an asset class that's 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 rather than the other way around.
Companies Capitalizing on Human Capital
As noted above, human capital means different things for different people—it just depends on who it impacts. And it's important to know just how they differ.
When it comes to companies and businesses, human capital refers to the value of an employee's skills and experience. This value is the economic value. This is passed on to the employer or company. Because it's intangible and can't be expressed in a dollar value, it doesn't show up on the balance sheet. Some of the characteristics employees bring to their employers include education, skills and training. Even traits like punctuality, neatness, loyalty, and leadership count toward a company's human capital.
Since employees aren't necessarily on the same level, employers can increase their human capital by investing in their pool of personnel by offering advanced training and education. This allows every worker to provide an economic value for their companies.
Human Capital and Financial Capital
Over your lifetime, your human and financial capital should go in opposite directions. When you first start out in your career, you have years of earning power that await you. But your financial capital is low because you probably haven't saved very much. 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.
Don't overlook the correlation between human capital and the stock market when it comes to asset allocation.
Below are two examples of how the risk characteristics of your human capital can affect the asset allocation of your financial capital.
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.
Income Volatility and Investment Risk
A real estate broker faces 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 financial assets that are less volatile and more liquid 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 that may arise from 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.
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. Make sure you 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. Always remain 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.