Tuesday, June 24, 2014

Human Capital, Financial Capital

The value of a young person's future earned income typically is much larger than the value of her savings and investments. In economics jargon, her human capital is much larger than her financial capital. Conversely, an older person has much less human capital and hopefully much more financial capital. Human capital is converted to financial capital by working and saving over the years. A higher savings rate converts more human capital to financial capital. The ratio of human capital to financial capital is an important consideration in determining ability to take risk in one's investment portfolio.

Consider a 30-year old with a $100,000 investment portfolio, an average, lifetime, real (inflation-adjusted) income of $100,000 per year, an average lifetime savings rate of 15%, and who plans to work another 30 years before retiring. This person's human capital is $3,000,000, of which $450,000 will be converted to financial capital by saving  (these numbers assume a real interest rate of 0%; at higher real interest rates the present value of human capital and savings will be less, but the risk-free return on savings will be higher). Even a 50% drop in portfolio value, $50,000, is small compared to future earning and saving potential, so this young investor has the ability to take significant risk in her portfolio in return for a higher expected return.

With lots of human capital there's also more flexibility to make up for poor investment returns. For example, one has more years to convert more human capital to financial capital through a higher savings rate. The options become more limited as human capital is depleted. Deciding to work longer increases human capital (although this may not be an option for some). Even when older, increasing one's savings rate increases the amount of human capital converted to financial capital, but of course the older one gets without building sufficient financial capital, the higher the savings rate required to meet one's retirement savings goal.

Although a high ratio of human capital to financial capital provides a relatively high ability to take risk, willingness to take risk also is an important consideration. Even though a 50% loss may not be significant relative to a young investor's human capital, it might feel so bad that the investor abandons investing in stocks entirely. So it may be wise for a young investor to hold a less risky investment portfolio, say 50% in stock index funds, until having lived through a deep decline in the stock market. After this experience it's more likely that the young investor will have a better sense of her willingness to take risk.

Someone who is retired and has no intention of working anymore has no human capital left. Unless this person is very wealthy or has significant retirement income from a pension and Social Security, ability to take risk with financial capital is very limited. There is no more human capital to convert to financial capital in the event that the latter is depleted by poor investment returns or high living expenses. This is a major reason why older investors typically should take less risk in their portfolios.

Starting young and maintaining a decent savings rate, say 15% of gross income, increases the odds that enough human capital will be converted to financial capital to provide for a comfortable retirement. Starting young also provides the benefit of more years of compounding returns. The later you start saving for retirement, the higher the savings rate required to convert enough human capital to financial capital to meet your retirement savings goal.

It's easier not to think about all of this, but it might be worthwhile thinking a bit about the importance of converting a good chunk of your human capital to financial capital by saving a decent portion of your income. Also consider the ratio of your human capital to your financial capital in deciding on the riskiness of your investment portfolio. It's tough to build up sufficient retirement savings without investing in risky assets like stocks, so I think it's reasonable for a young person with lots of human capital to allocate a significant portion of her investment portfolio to stock index funds. An older person with minimal human capital and other sources of retirement income probably is wise to take much less risk with her financial capital.

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