If I were a rich man. . .
We tend to regard wealth as financial assets, large houses, and nice cars accumulated through a life of hard work. Yet that is to view wealth in narrow terms; on the very day we are born we are wealthy in terms of our human capital, or in other words, the present value of all the future earnings that we will generate over our working lives. This needs to be reflected in how we invest during the accumulation phase of investing.
As younger people have a long time to go before they will need the money, the advice they receive is often that excess earnings should be invested predominantly in equities. A subtler approach takes into account the attributes of each person’s human capital, which ranges from bond-like to equity-like in nature. Take for example a university professor and a fin-tech entrepreneur; the former has a stable income, linked to inflation and job security; the latter has little income stability and, most likely, a high correlation to the equity markets. The professor’s human capital acts like a bond, the entrepreneur’s as equity.
So, if they are both 40 years old and have the same level of financial capital, should they invest in the same way? Intuitively, the answer is no.
Human capital should be treated like any other asset class; it has its own risk and return properties and its own correlation with other financial asset classes.
Ibbotson, Milevsky, Chen and Zhu (2007)[1]
Those with more bond-like human capital could well take on more risk and those with more equity-like human capital should, perhaps, take on less risk with their financial capital. Ironically, it is also possible that those who choose steady, stable jobs may have a lower tolerance to losses than the entrepreneur, and vice versa. One can see the risk of this scenario. Additionally, two partners may also have different levels of risk in their human capital. Imagine a professor married to an entrepreneur; together they form a balanced portfolio between bonds and equities and their investable portfolio of financial capital should reflect this.
Figure 1: How human capital attributes influence asset allocation
Source: Albion Strategic Consulting
Cash-flow modelling can help those in the accumulation phase of investing to understand the financial impact of changes to their human capital. Owning sufficient life cover to protect the outstanding human capital should be an important part of the discussion. It is difficult to see how a stockbroker or investment manager can structure a portfolio sensibly, particularly where the investor still has substantial human capital, without the insight into, and modelling of, the client’s total asset picture. No financial portfolio is an island.
[1] Ibbotson, Milevsky, Chen and Zhu (2007), Lifetime Financial Advice: Human Capital, Asset Allocation and Insurance, Research Foundation of CFA Institute publication.
Risk Warning
This newsletter does not constitute financial advice. Remember that your circumstances could change and you may have to cash in your investment when the value is low. The value of your investment and any income from it can go down as well as up and you may not get back the original amount invested. Past performance is not necessarily a guide to the future. If you are in any doubt you should seek financial advice.
Max Tennant - February 2017
Check out more of the latest news from IFAMax:
Pay less attention to weather forecasts