One of the major trends in finance in recent years is the increasing popularity of the “human capital” concept. In case you’re not familiar with the idea, your human capital is defined as the value (as measured today) of all of your future earnings from work.
In short, the ramifications are that:
- Over time, you must accumulate financial capital in order to make up for the fact that your human capital is being depleted as you move toward retirement (at which point it will be mostly, or entirely, depleted), and
- When considering how much risk to take on in your portfolio, you should consider how much risk you’re already taking on via your human capital.
How About a Few Examples?
Janelle is 24 years old, and she is employed by the federal government in a position with a great deal of job stability. In other words, she has a great deal of human capital (because she’s young, with many years of work ahead of her), and it is very low-risk. As a result, Janelle can afford to take on a good deal of risk with her portfolio.
Geoffrey is 28, and he’s self-employed in a business with an unpredictable income. Because Geoffrey’s overall economic picture is dominated by a large amount of high-risk human capital, he should probably take on very little risk with his portfolio.
Beth is 68 years old and retired, with no intention of going back to work. At this point, her human capital is depleted. Beth can afford to take on a moderate amount of risk with her portfolio.
(Important caveat: All of the above examples are extreme simplifications, ignoring numerous other factors that would typically affect a person’s risk tolerance.)
Human Capital and Investing Guidelines
Most often, when I see human capital brought up in a book or article, it’s as a rationale for why most investors should shift toward more conservative allocations as they age. The idea is that most people’s human capital is bond-like (because most people’s income is relatively stable), so as their bond-like human capital decreases, they should increase the allocation to bonds within their portfolio.
That’s fine, as broadly-applicable guidelines go. But I think the more useful application of the human capital concept is to use it as a tool for contrasting different people’s economic situations and considering how they should tailor their portfolios accordingly. If your human capital is high-risk, it’s not particularly relevant that most people’s human capital provides a nice, safe, bond-like income.
The common sense takeaway: The riskier your job, the less risk you should take on in your portfolio.
Hi. I'm Mike Piper, the author of this blog. I'm a CPA and the author of several personal finance books. The point of this blog is to show that investing doesn't have to be complicated. 
Good post and something for investors to consider. Over the years I’ve known a few commodities traders and many of them had rather conservative portfolios to offset the risks they took professionally.
You must check out Zvi Bodie’s Risk Less and Prosper. A wonderful investing book with a big focus on human capital.
Barbara,
I enjoyed that book as well — far more than I enjoyed Bodie’s Worry-Free Investing. While I think TIPS are a very useful tool, many of the specific suggestions he made in the earlier book didn’t make much sense to me.
With the low interest rate environment now, I’m investing the max for my spouse and I in I bonds and am waiting for a boost to yields before going back into TIPS (for the fixed portion of our allocation).