Human Capital

Human capital reflects your expected future earnings. Surprisingly, most financial planning algorithms ignore human capital, while focusing on risk tolerance and time horizon. In fact, all three factors should be considered when designing a retirement savings plan.

Generally, an investor with a high risk tolerance and a long time horizon will choose an aggressive asset allocation strategy (emphasizing stocks over bonds). Conversely, a risk-averse investor with a short time horizon will adopt a more conservative approach (emphasizing bonds). How does human capital influence this decision?

Like your investment portfolio, your human capital has some risk associated with it. For example, a professional movie actor has a much riskier expected income stream than a physician. Assuming they both have similar risk tolerances and time horizons, how should their investment portfolios differ?

A young physician who has just graduated from medical school has little or no investable assets and a relatively large amount of expected future wages. Her future income stream is subject to some risk, but is nevertheless relatively secure. Since most of her total wealth is represented by low-risk expected income, she can afford to take on a substantial amount of investment risk. As years go by, her investment portfolio will represent a larger share of her total wealth while her low-risk expected future earnings will diminish. To keep her total financial risk constant, she will have to reduce the risk of her investment portfolio over time.

A professional actor at the beginning of his career should take a different approach. He also starts with no investable assets and high hopes for future earnings. However, his human capital is risky. Since most of his total wealth is represented by high-risk expected income, he should minimize his investment risk in the early years. If he saves diligently, his investment portfolio will eventually represent a larger share of his total wealth allowing him to take on more investment risk later in his career.

Risk preferences, investment time horizon, and human capital should all be considered in the asset allocation decision. Even then, there is no formulaic solution. Your investment goals and individual circumstances should also be taken into account, but that is a topic for another day.

October 2004

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