If you ask most people what their total wealth or net worth is, you’d probably find that they list all their assets such as equities, property, cash, fixed income instruments and other stuff such as gold or silver coins and bullion. But would they include the fact that they would earn income from work for a good part of their lives? I think not.

Most people probably think linearly that savings is whatever’s left from income after meeting monthly spending requirements. And investments are whatever savings are channelled into. That would make sense from a cashflow point of view but how many of us would consider the impact of our future income from an asset allocation point of view? But before we get there, let’s figure out what exactly is human capital.

What is human capital and why is it important?

First of all, what is human capital? Human capital can be defined as the economic present value of an investor’s future labour income. Basically, it is the sum of ALL income earned by an investor in the future and discounted back to the present. By this, we can then surmise that in general, the younger one is, the more human capital one has. And as one ages, human capital drops while financial assets (should) increase.

Also, the amount of income that we (would) earn over a lifetime of work would make up more than a substantial percentage of our total net worth. According to Lee and Hanna (1995), the ratio of financial assets to total wealth (including human capital) for the median household in the US is 1.3 percent. Therefore, the optimal asset allocation must take into account the amount that one is likely to earn over their working life.

If human capital makes up almost all of one’s total wealth, then isn’t it going to be a major factor when considering how much to allocate to different asset classes in one’s portfolio? Just imagine that you are a young person just starting work and going by conventional standards, financial advisors are going to advise any young person to invest more of their assets in equities because they have a long time horizon and need to let the power of compounding take effect. However, they might also say to put 20% of the portfolio in bonds just in case the market tanks or to diversify or whatever. Ignoring human capital, this would be a classic 80/20 equity-bond portfolio which may sound reasonable. However, if we take into account the fact that most of a young person’s wealth is in the form of human capital and that human capital, for most people, is pretty much uncorrelated with equity markets (David and Willen, 2000), then wouldn’t the young person be better off with a full 100% allocation to equities?

The nature of human capital

Ok, so not everyone is in a job where their income is unrelated to the financial markets. In that case, one needs to figure out the correlation between one’s human capital and the financial markets. The more correlated one’s human capital is to financial markets, the more one should allocate to risk-free assets.

However, one’s income may also not be correlated to financial assets but yet be considered risky. For example, a job where the chance of being replaced by automation is high. In this case, human capital should be treated as a risk-free asset but the overall risk of the entire portfolio should be reduced.

If your human capital is bond-like in nature, then you should be allocating more of your financial assets to risky assets. Good examples of this would be anyone working as a civil or public servant in Singapore. There is virtually no worry of loss of income through retrenchment and while the pay may not launch you (unless you happen to be one of those scholar types) into the top 5% in terms of household income, it is pretty decent. Most executive level positions in the civil service typically pay slightly above the median wage, effectively putting these group of people into the upper middle class. In this case, a young executive type civil servant should be putting all his financial assets into equities due to the bond-like nature of the his human capital as well as his long time horizon.

Other factors

Obviously the current level of wealth will play an important role in asset allocation. The more wealth one starts with, the less one should allocate one’s financial assets to risky assets since a lower level of total return will be required to achieve the necessary level of assets when one’s human capital is diminished.

If wage growth is also tied closely to the returns in the stock market, then one needs to allocate a higher level of financial assets to risk free assets. That way, the upside from risky assets are already captured within human capital and the downside of both human capital and risky assets can be mitigated by the increased allocation to risk free assets.

In short, the more bond-like and greater (for younger people) one’s human capital is, the less an allocation one needs to risk free assets. If so, go around and ask how many of your friends in the civil service are heavily invested in the stock market. Conversely, go around and ask how many of your friends whose daily bread is tied to the financial markets whether they have much of their assets invested in the equity markets.

In the next part, we’ll see how human capital is affected by two things- life and death.

Endnote: Civil servants aren’t saints. Most do their job and expect to get paid. If they could retire early, I suspect most would. So why not allocate a higher percentage to risky assets? I suspect most of them either don’t know how or haven’t even thought of the issue.

This is part of a series I’m doing as part of revision for my CFA level 3 exam. All references are based on CFA textbook material and any interpretations (rightly or wrongly) of the material are my own.