Human Capital vs. Financial Capital

A person’s net worth is generally considered the sum of financial assets (stocks, bonds, savings) and real assets (automobiles, real estate) less debts (mortgage, credit cards). But this view fails to account for Human Capital—the value of all future wages. For younger workers, Human Capital is generally much larger than accumulated Financial Capital.

Human Capital is considerable when we are young and have many years of productive employment ahead. As we grow older, the present value of our Human Capital shrinks as the number of years until retirement narrows. Ideally, during our working years, we manage to save and invest so that Financial Capital increases as our store of Human Capital declines.

The concept of Human Capital is useful when thinking about retirement planning and selecting an appropriate investment strategy. Conventional wisdom says to be more aggressive when you are young—with a long investment horizon—and gradually become more conservative as you get closer to retirement. A long time horizon allows you to endure a bear market that might significantly impair your standard of living if it hits in or close to retirement. Your Human Capital is also large when you are young, providing balance to an aggressive investment portfolio.


Are You a Stock or a Bond?

The stream of income you earn working can be valued similar to cash flow received from a bond or other traditional investment, certainly not a precise calculation, but potentially a useful exercise. One of the most significant unknowns in this exercise is determining the certainty of future earnings. The more stable and secure your employment, the more “bond-like” your future earnings should be treated, supporting a low discount rate. On the other hand, in today’s economy, perhaps no career is completely secure, and even stable careers may be more like high-yield bonds. If your career trajectory is uncertain or volatile, a higher discount rate should be applied to future earnings.

Below is an example of how one might value their Human Capital. We assume future earnings growth at a real rate—after inflation—of 2% annually and illustrate the present value of each $10,000 in current after-tax income. For example, if you take home $50,000 annually after tax and have 30 years until retirement with a stable career, your Human Capital is about $1.27 million (calculated as ($50,000/$10,000) * $254,000). Alternatively, if you take home $100,000 annually after tax, but are in a more volatile job with only 5 years until retirement, your Human Capital is about $430,000 (($100,000/$10,000)*$43,000).


Example of Calculating the Value of Your Human Capital
Present value per $10,000 of after-tax income (real $)

Years Until Retirement
40 Years 30 Years 20 Years 10 Years 5 Years
Stable Career (3% disc. rate) $323,000 $254,000 $177,000 $93,000 $48,000
Volatile Career (7% disc. rate) $171,000 $152,000 $123,000 $76,000 $43,000



Selecting an Investment Strategy

So how does this help formulate an appropriate investment strategy? Consider if we include the value of Human Capital when determining your asset allocation. Building on the prior example, if you have 30 working-years ahead and $100,000 in cash to invest, your total net worth would be $1.37 million ($100,000 in cash and $1.27 million in Human Capital from the calculation above). With a stable career, you already have over 90% of your total capital in a bond-like investment (your career), and therefore even a 100% allocation of your investment portfolio into a higher-risk, all-equity portfolio might be considered a relatively conservative approach. Conversely, if you are in a highly volatile career, especially one with strong ties to the financial markets, your Human Capital might be more equity-like, and you may decide to favor conservative fixed-income investments.

Calculating the value of your Human Capital is imprecise—more art than science. Although inexact, it does allow consideration of future earnings potential when setting an investment strategy, and can be used to tweak the portfolio risk up or down relative to more traditional recommendations.

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