Dealing with a lot of clients in or nearing retirement, I would get a lot of questions about whether or not they had a large enough portfolio (or financial capital) to maintain their lifestyle throughout their retirement years. Once they understood what they had and then what their budget was, they were fairly comfortable with the process of receiving a “paycheck” from their investments and didn’t worry too much about their investment returns. What I find funny, though, is that it’s the younger clients who seem most worried about maximizing the returns on what little financial capital they do have. And I’ll tell you what I tell them, “Focus on what you can control!” What you can control, unlike the markets, is your earning potential, also known as human capital.
What is Human Capital?
From a personal finance perspective, human capital is the present value of everything you will earn over your lifetime. In other words, it’s all future earnings reduced by taxes and inflation in order to quantify those earnings in today’s dollars. If you are young, it is likely the most valuable asset you have. This is because you have a much longer time to accumulate earnings. What that means, though, is the more that you can increase your wages early on in your career, the more you can significantly increase the overall human capital portion of your financial snapshot because you can also assume you will earn incrementally more in future years of your career. Point being, don’t be shy about negotiating a raise.
From an investment portfolio perspective, human capital really represents your ability to save. If you assume your living expenses remain about the same as you earn more money, you can use the excess in earnings to put toward your future. So as you get older, and as you save more, a larger portion of your human capital would then convert into financial capital and thus a larger portfolio when you need it.
For a basic example, let’s say you earn $50k per year, are living comfortably and saving 15% of your after-tax pay (about $5k per year). You also have a $20k investment portfolio earning an average of 7%. A jump in investment return from 7% to 10% would make you a whopping $600 for the year. In contrast, if you could make an extra $5k per year without increasing your lifestyle at all, you could save an additional $3,300 after taxes.
This is why I stress the importance of developing your human capital (and a solid savings plan) rather than squeezing out every single drop of returns in your investments. It will have a larger impact on the size of your portfolio early on, and for most of you, it’s something you have much more control over.
Take a look at the graph below. It shows how your human capital and financial capital will typically change throughout your life, if done right.
How does the human capital concept affect your asset allocation?
The answer to this question, like so many other asset allocation questions is, “It depends.” There is no cookie-cutter approach here because everyone has different types of jobs, employee benefits, and other assets that they “own” (such as pensions, Social Security, or real estate) that may not be as liquid as stocks or bonds. Each of these “asset classes” affect what human capital does to that person’s overall net worth. The key here, though, is that human capital should be considered as a part of your allocation and that it should transition into the financial capital portion of your allocation as you get older. It’s a fluid piece of your financial pie that needs to be accounted for and altered throughout your life.
Traditional wisdom would say that you want to treat your human capital similar to fixed income. Because of that, you would put more of your financial capital (investments) in stocks to get you as close to the standard 60/40 stock to bond ratio as possible. There is some logic to this because your human capital can be an added hedge against inflation and will help stabilize your financial life in years when markets are down. As I pointed out earlier, though, depending on what short-term liquidity needs you have, you may want to scale back on the aggressiveness of your investment portfolio. That’s something for you to figure out on your own or with an advisor.
6 Potential Ways to Improve Your Human Capital
- Education – achieving a higher level of education may allow you to earn more at your current job or a similar one. However, be careful with this. Spending the money on education, which can be expensive, may not actually earn you more money. You will need to evaluate your own personal situation.
- Improve job related skills – similar to achieving a higher level of education, improving your job related skills make you more valuable to your current employer. It makes a more compelling argument for you when you ask for a raise.
- Ask for a raise – You don’t get what you don’t ask for. I included a link earlier about how to negotiate a higher salary. Here is another.
- Find a higher paying job – If you believe you are worth more than what your company is paying you, and/or you are unhappy for whatever reason, find another job that pays more. Don’t quit your current job until you’ve found another one, though.
- Generate side income – A “side hustle” has the ability to earn you extra income, which can be used to increase your savings. If you start making enough from the side hustle and the income looks like it will continue to grow faster than at your current employer, it may be time to start spending more time on that business.
- Start a full-time business – Often times the first few years can be financially and emotionally draining, but if you are entrepreneurially inclined, starting a business also gives you more control over your income and offers the potential for far greater income in the long term. Before quitting your job and diving head-in to a new business, though, be sure to do your research and come up with a good plan and back-up plan. Depending on your personality, discipline, and drive, it may not be a bad idea to start as a side gig to test the market before dedicating your time to the business.