At the start of your career you normally have very little financial wealth. This is because generally, starting salaries are low and as such, most of it is likely to be allocated towards paying for basic necessities such as rent, car payments or paying off study loans. You do however have a very important financial asset that many people tend to overlook: yourself.
It is at this beginning stage of your career when most of your wealth is in the form of human capital - the potential to earn and accumulate wealth. Over the course of your life you will likely convert your human capital into financial capital in the form of retirement savings, physical property and other discretionary investments. You can (and hopefully will) increase your human capital through further education and experience which will most likely manifest itself in the form of above-inflation increases in your salary.
Then, as time progresses and you continue to accumulate financial wealth, the number of years left available to you to continue to earn an income decreases (i.e. before you retire) and your human capital starts to decrease as a percentage of your total wealth (financial capital plus human capital).
The progressive conversion of human capital into financial wealth is illustrated in the graph below, where we look at the growth of retirement savings over a working career of 40 years. We have used the investors wealth multiple which is equal to the total accumulated retirement savings at any given time divided by the current annual salary.
The illustration below shows that an investor who saves prudently and preserves their retirement savings when they change jobs, could over a 35 to 40 year period, end up with around 12 to 16 times their final salary at retirement. Over the same period however, their human capital as a percentage of total wealth decreases steadily as they near retirement. Retirement savings then become their source of income when they are no longer able to generate an income from their human capital, i.e. are no longer working.
Protecting your human capital
Human capital is arguably one of your most valuable assets and it follows that you should strive to protect it against risks such as death and disability.
Life insurance and disability cover is essential to guard against human capital loss, especially for anyone who has dependents. Because human capital decreases as a percentage of your total wealth, you will likely require more insurance for your human capital when you are young (and human capital makes up most of your wealth) and less insurance for your human capital when you grow older (and financial capital makes up most of your wealth).
Another potential risk to human capital is that skills or a job could become redundant as technology and innovation advance within industries. With this in mind, staying abreast with developments in your industry and continuously improving yourself in terms of your skillset is crucial, and can ensure that you are able to keep your skills relevant - thereby protecting or even enhancing your human capital.
Types of human capital
The nature of your employment determines the risks associated to your future earnings and human capital. In this sense, there are broadly three types of human capital to consider:
- Safe human capital
This would describe a very stable job such as a teacher, academic or someone employed by government.
- Volatile human capital
In this case income can vary (sometimes dramatically) from year to year. For example, any job that is based on a commission or bonus structure, a professional sportsman or an entrepreneur.
- Correlated human capital
This describes industries that are linked to higherrisk assets such as equity or listed property. These are normally cyclical industries such as mining, especially if you are compensated through share options.
Over the course of your career it is plausible that you may be in any one or a combination of these three broad categories of human capital. Therefore, it’s imperative that you regularly consider and account for the risks associated to your human capital, particularly when you are constructing and reviewing your investment portfolio.
How do you take human capital into consideration when constructing your portfolio?
At the start of your career, it’s likely that you have very little financial capital with the majority of your wealth being in human capital. Therefore, you can take on more investment risk than when you are nearing retirement.
In other words, compared to equity market risk, your human capital is seen to be significantly less risky and may even be viewed as having bond-like characteristics. As you get older and convert your human capital into financial capital, your financial capital becomes the majority of your total wealth. This means that you should start decreasing your exposure to risk assets because your potential for future earnings decreases and severe market conditions have the potential to result in irreversible financial damage.
Take for example a 55 year old that lost his/her job after the financial crisis. They may be forced to draw from their pension savings to survive. If this investors’ portfolio was too aggressively positioned relative to their level of human capital (this would be relatively low) at that life-stage, they would have lost a significant portion of money and may not participate in the market recovery following such an event.
This example shows that one should not just look at market drawdowns in assessing your risk. It is crucial to consider the broader economic context and your level of human capital within that context.
So how should one incorporate human capital when determining the risk level of an investment portfolio?
Below we illustrate how, depending on the type of human capital in question, exposure to equities decreases as human capital (as a percentage of total wealth) declines. Broadly speaking, an investor who falls into the category of ‘safe human capital’ could be fully exposed to risk assets until human capital is equal to financial capital (wealth multiple of 8 in our retirement example above).
Thereafter, exposure to equities progressively decreases until the appropriate level of equity exposure during retirement (we have used the multi-asset low equity categories’ maximum equity exposure as a guideline). On the other hand, an investor who falls into the ‘volatile human capital’ or ‘correlated human capital’ categories would look to decrease equity exposure much earlier.
The maximum level of equity exposure allowed within a retirement fund as determined by Regulation 28 of the Pension Funds Act, is also shown on the above graph. If human capital is taken into consideration it can be seen that younger investors investing in a typical retirement fund will take on too little risk while older investors, with the majority of their total wealth in financial capital, could be taking too much risk (as in the example of the 55 year old losing their job).
As it is unlikely that these limits will be lifted in the near future, it is advisable that investors re-asses their discretionary portfolio to compensate for this mismatch in risk.
Human capital is your most important asset, and quite often this asset is ignored in financial and retirement planning. By incorporating it into a financial plan and therefore taking the appropriate investment risks at the right stage of their career, investors can improve the overall management of their financial wellbeing.