Traditional assessments of wealth tend to measure a person’s financial capital, by tallying up assets like property, investments, and savings. However, these assessments often overlook a critical component of wealth: human capital.
An individual’s total economic net worth extends beyond financial assets and includes both human capital and financial capital, both of which have unique risk characteristics.
Understanding Human Capital
Ibbotson, Milevsky, Chen, and Zhu (2007) define human capital as the net present value of an individual’s expected labour income weighted by the probability of survival to each future age. In simpler terms, human capital is the value of your knowledge and skills on the job market, and the stability of your income throughout your career.
Human capital can be seen as an asset class all its own, with unique characteristics and risks. Different professions have varying degrees of income stability. For instance, government workers and teachers often enjoy a more predictable income than race car drivers or self-employed people. For most individuals with high job security, human capital can be seen as a bond-like asset, paying a predictable stream of income over time.
As investors age, the fundamental nature of their total wealth and the risks they face evolve. Throughout your career, you essentially convert human capital to financial capital by saving and investing a portion of your employment income.
Early Career
Younger investors often have limited savings and financial assets. They spend time and resources building up their careers and investing in knowledge and skills. Because human capital is such a substantial part of a younger investor’s economic wealth, there’s a greater need to protect yourself against risks that affect your employment.
A predominant risk younger investors face is earnings risk. This is the risk of losing the income you, or your family, depend on to live, which can be triggered by health issues or becoming suddenly unemployed. Earnings risk can also affect your financial capital if you must deplete the assets you own to make up for the loss of income. A proven way to mitigate earnings risk is by purchasing insurance or building an emergency fund.
Career Development
As you advance in your career and accumulate financial assets, managing human and financial capital-related risks can be achieved by optimizing your portfolio’s asset allocation.
Diversifying into sectors with little correlation to your profession can help safeguard your portfolio. For instance, let’s say a substantial portion of your portfolio is heavily invested in the stock of your employer. In the unfortunate event that the company underperforms, goes bankrupt, or you’re otherwise let go, your overall wealth would decline significantly due to the simultaneous loss of income and the decrease in the value of your stock holdings. Similarly, suppose you have a job with an unpredictable income stream that can change from month to month. In that case, you might want to compensate for this volatility by investing in industries or companies that are less volatile – with stable dividend and interest income – and that are uncorrelated to the industry you work in.
Pre-Retirement
As you advance in your career, accumulate assets and have fewer years of work left before retirement, your financial capital will become increasingly more important than your human capital.
Investors usually begin thinking about retirement and tax planning once they’ve accumulated some level of financial capital. At this stage of life, you’ll want to focus on mitigating risks that affect financial assets. For some investors, this means increasing the portion of their portfolio allocated to safer investments.
Retirement
The later years of retirement can be unpredictable. No one knows how much time they have left. Older investors face longevity risk, which is the possibility that their savings and financial assets become exhausted after retirement. To mitigate this risk, some people will choose to work more years and retire later, adopt a more modest lifestyle, purchase annuities, or a combination.
Understanding how your wealth and its associated risks will change throughout your life is instrumental in crafting an efficient financial management strategy. Taking a comprehensive view of all the components that make up your total wealth, can help guide you and your family’s changing needs.
