Human Capital versus Financial Capital

If someone were to ask you for your net worth, you would most likely just add up your financial assets and subtract your financial liabilities. But this would give an incomplete picture, since human capital is an important component of net worth.

What is human capital? It is defined as the present value of an investor’s future labor income. The discount rate you would use depends on the nature of the employment. For a safe job in government or a tenured college professor you would use a lower discount rate. For a riskier job- say a commission-based job, or something where income is highly variable, you would use a higher discount rate.

There are some additional complications. Suppose you take an early retirement, but still have the skills and ability to work again if you wanted to. The human capital calculation should not be zero, but should factor in the probability of returning to work at any given year.

In the extreme case of death, human capital goes to zero.

Most young people have far more human capital than financial capital. They have more years left to work and have had fewer years to save and accumulate financial wealth. Older investors tend to have more financial capital than human capital. They have fewer years ahead to work but have had more time to accumulate financial capital.

Here are some important points to know about human capital and financial capital:

1)    Human capital is not traded and is highly illiquid, but it can be hedged using life insurance.

2)    Some forms of human capital are more like a stock. An example would be a commission job on Wall Street where compensation is highly correlated with the markets. Other forms of human capital are more like a bond. An example might be a safe government job.

3)    Assuming the same income level, the need for life insurance is actually higher if you have a safe low risk job. The discounting rate is lower, so your human capital is higher than if you had a riskier job. So a tenured university professor or a Civil Service worker who has human capital similar to a bond should purchase more life insurance and invest relatively more financial wealth in stocks.

4)    For a person with a risky commission based job, their human capital is more like a stock since the income is closely correlated with the market, so human capital is highly uncertain. He should purchase relatively less life insurance, and invest more of his financial assets in bonds.

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One response to “Human Capital versus Financial Capital

  1. Reblogged this on socialhumanrace and commented:
    Helpful ideas for my mind’s grasp, getting a handle!!

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