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Definition of Human Capital
Your total wealth is your assets minus liabilities, for a typical household you can group assets into:
- Liquid assets
- Fundamental Assets
- Investment Assets
- Human Capital
We define human capital as the present value of your future labour income and social benefits society entitle you to. When you work you are exchanging labour for a monetary reward. The monetary reward you earned is a dividend or an interest payment on your human capital. If you are fortunate enough to live in a country with a social security system, your human capital has another component. This component is any social security benefits the state entitles you to, such as old age pension, child grant, medicare etc.
Table of Contents
- Traditional View on Asset Classes
- Capital Assets
- Consumable or Transformable
- Store of Value Assets
- Human Capital
- Reference or Additional Material
How you spend your time impact you human capital
Human capital is not as liquid as other asset classes. One of your life choices (assuming you are not in survival mode) is deciding how you spend your time between work and leisure. The career you choose, do you want a high paying stressful job with little personal time or a career with less stress and lower monetary compensation but a higher return on your free time when not measured in monetary terms.
This choice you make is you maximising your lifetime utility by how you consume your time. Consumption is the factor driving your utility, it needs to be seen beyond the narrow materialist definition. These decisions directly impact the value of your human capital, not necessarily the utility you get out of life.
Most times when you are young it is your largest single asset. When you are still young, you have far more human capital than financial capital. As you have not yet traded your human capital for financial capital. As a young person, you still have a longer period to work and to invest into financial capital. You still have potential to increase the exchange rate of your human capital for financial capital.
Older investors in theory have more financial capital than human capital, as they have already exchanged much of their human capital into financial capital. Their time window to convert human capital to financial capital is also smaller, resulting in a lower present value of their human capital.
Converting Human Capital into Financial Capital
For many human capital is their largest single assets. It is also the asset you have the most control over and can more easily change in value directly related to the choices you make. It is very important you treat your human capital just like any other asset. Just like you would take insurance on your home, you need to consider taking insurance on your human capital. Like you would care for your car, you need to care for your human capital. Your human capital is unique to you, with its own risk and return profile and correlation with other traditional assets and liabilities. Your investment plan needs to incorporate your human capital, when performing your asset allocation modelling and mapping your liabilities.
Graph above illustrates the evolution of your forms of wealth overtime assuming your human capital is risk-free. By risk free we assume you are employed the entire time, and you do not suffer any accidents that impact on the value of your human capital. The illustration assumes you worked from the age of 20 earning $60 000 a year, with an annual salary increase of 2% equal to the inflation rate. The model assumed you were employed the entire time of your working life, hence risk-free asset. The discount rate used is 3% roughly the annual yield of a 10 year treasury bond.
You can save 20% of your annual income, or seen differently you are converting 20% of your human capital in to financial capital. This is invested simplistically into a portfolio of 40% fixed income yielding a return of 4% or inflation plus 2%. The remaining 60% allocation to equities generating a return of 8% per annum.
Chart 1 - Human Capital as a Risk Free Asset
Human Capital as a Risky Asset
The chart 2 below has the same assumptions, the only difference is:
- 3 years of unemployment, when you are 30, 40 and 50
- 5 years after unemployment period, no salary increase
- Followed by 5 years of salary increase of only 1% or 50% of inflation rate
Your human capital is on a much lower trajectory as illustrated by the line for human capital-risky. The line labelled human capital is exactly the same as in the previous graph, and it here for comparative purposes.
Chart 2 - Human Capital as a Risky Asset
Impact of Human Capital as Risky Asset
Treating human capital as a risky asset the impact on the value of your human capital is a reduction of $421 167 over your lifetime, financial assets are less by $328 016. The growth (what you earn) on your savings remained unchanged, you still saved 20% of your income. The difference is the absolute amount is less, since you lost 3 years of income and your salary increase was less. Contribution to your savings pool is lower. The growth you missed out on is around $82 818. This is a significant impact on your overall wealth. This is illustrated in Table 1 to the right.
Table 1 - Impact of Human Capital as a Risky Asset on Total Wealth
|$ 2 169 576
|$ 1 748 408
|$ -421 167
|$ 2 137 877
|$ 1 809 861
|$ -328 016
|$ 891 966
|$ 646 768
|$ -245 198
|Growth on Savings
|$ 1 245 910
|$ 1 163 092
|$ -82 818
|Total Wealth Reduction
|$ -1 077 200
Chart 3 - Wealth impact of Human Capital as a Risky Asset
Human Capital is an Asset Class with Unique Characteristics
The risk to your human capital is not just unemployment, the risk can manifest as ill health, accidents impacting on your ability to work in your chosen field. Or your human capital can be reduced to a lifestyle choice to take a break from work to spend time on other goals you have in life. This does not mean you will have a negative overall life.
Your optimal choice to maximise your life utility might be to have lower human capital. You will see later one needs to look at the correlation of your human capital to other asset classes and your life goals. Just like other asset classes, human capital has its own risk and return properties and its own correlation with the other asset classes.
There is another risk dimension we will explore in the section on portfolio construction with human capital. Depending on your job, your human capital might have a high correlation with your financial wealth based on assets you invest in. This creates optionality for you. Where you can choose a lower risk investment to offset the risk in your human capital but have lower returns. Or keep more risk on the table and should worse happen, you use that time to pursue other life goals. It should also be clear just as negative events impact your human capital, it is in your power to increase your human capital. By increasing your skills through education, or strategically choosing a career path.