Economists use the term human capital to describe the present value of future labor income. What does this mean and what does it have to do with investing?
Labor income is the income earned from labor; e.g., job income or salary.
For example, assume a constant, after-tax, real (inflation adjusted) annual labor income of $100,000. At a real interest rate of 0%, the human capital represented by 30 years of this future labor income is $100,000 x 30 = $3,000,000. At higher real interest rates, the present value of the future income is less, since it must be discounted by the real interest rate:
- Using a real discount rate of 3%, the present value of annual income one year from now is $100,000 ÷ 1.03 = $97,087.
- The present value of cumulative annual income two years from now is $97,087 + ($97,087 ÷ 1.03) = $191,347.
- The present value of 30 years of this future real income, discounted at a real rate of 3%, is $1,960,044.
Role in investing
A common investing guideline is to decrease the portfolio's ratio of equity securities (stocks) to debt securities (cash and bonds) as one ages. The rule of thumb of holding one's "age in bonds" is an example. One rationale for this is that human capital can be thought of as an inflation-indexed bond.
Young investors typically have much more human capital than financial capital (the value of their savings and investments). Considering human capital as bond-like enables young investors to take more risk by allocating more of their portfolio to stocks. Younger investors have many years to transform part of their human capital into financial assets by saving and investing. They also have more opportunities to use the savings generated by their human capital to buy stocks when prices decline.
Older investors have less human capital, and therefore cannot afford the risk of higher equity allocations. They have less time to transform their human capital into financial assets; i.e., less time to earn, save, invest, and take advantage of stock market declines.
Role in insurance
When you are young, your main asset is your human capital. If you have dependents, you want to protect your future earnings by buying enough life insurance. For young Canadians, human capital is a large number (see the calculator under External links), and buying life insurance with such a large death benefit is only affordable by choosing term insurance.
As time passes, human capital is progressively depleted (you have fewer years of work ahead), and hopefully financial assets accumulate in preparation for retirement and perhaps the children's education. Therefore, your life insurance needs decrease, possibly reaching zero upon retirement, if all your assets can be transferred to your spouse.
- Bodie, Merton (2000). Finance. Prentice-Hall, p. 146 (ISBN 978-0133108972)
- Discounting translates the future income amount to an equivalent amount of income today.
- Bernstein (2010), The Investor's Manifesto. John Wiley & Sons, Inc., p. 76 (ISBN 978-0470505144)
- Moshe Milevsky (March 30, 2010). "The lowdown on insurance salesmen and warranty peddlers". The Globe and Mail. http://www.theglobeandmail.com/globe-investor/personal-finance/the-lowdown-on-insurance-salesmen-and-warranty-peddlers/article1516009/. Retrieved January 21, 2017.
- M.A. Milevsky, Is your client a bond or a stock, Advisor's Edge, November 2003; general discussion on the human capital concept, and how it can influence portfolio decisions.