Human Capital

AS WE TRY TO WRAP our arms around this sprawling thing we call a financial life, we might begin with what’s often our most valuable asset—ourselves. Economists refer to our income-earning ability as our human capital. Our regular paycheck—or lack thereof—should figure into a slew of financial decisions, including how much debt we take on, how much emergency money we need, how much we should save for retirement, what insurance we purchase, and what mix of stocks and bonds we buy.

Suppose you’re a government worker with a steady job and a traditional pension upon retirement. You may not have huge lifetime earnings, but your paycheck doesn’t involve much risk. That means you can probably take a fair amount of risk elsewhere in your financial life, including investing heavily in stocks and using an adjustable-rate mortgage to buy your home. By contrast, if you’re a small-business owner, you are taking a heap of risk with your human capital—and you may want to favor bonds in your portfolio, keep your debts modest and build up a large emergency fund.

Your human capital is also the reason it’s possible—and even rational—to borrow heavily early in your adult life. That debt can allow you to purchase a college education, a house and maybe a car, thus jumpstarting your financial life. But you should be careful not to take on more debt than you can comfortably handle and you should aim to pay off all loans by retirement, and preferably sooner.

In addition, you’ll want to protect your human capital, which means buying health and disability insurance, and perhaps also life insurance if you have a family that depends on you financially. Maybe more important, you should save part of the income generated by your human capital, so that one day you’ll no longer need a paycheck and you can retire. No longer working? That should be reflected in your investment mix. Because your portfolio will now have to generate the income once provided by your job, you’ll want to invest more conservatively, with perhaps a 50-50 split between stocks and bonds.

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