Before preceding I would strongly encourage my readers to read my article "How much Risk can you afford?" at http://pakinvestment.blogspot.com/2010/12/how-much-risk-can-you-afford.html if you have not read it beforebecause this might help you to understand this article better.
The purpose of this article is to reveal the presence and importance of an asset that most of us do have but have not been able to recognize it. We call this asset “Human Capital”. However, before describing it let me first briefly introduce some necessary concepts that would help you to understand what I want to tell you.
FIXED INCOME VS NON-FIXED INCOME
Most of us make investments in our life. We can divide these investments into Fixed Income and Non Fixed Income investments. In a fixed income investment you know what you will get after a specified period of time. For example if you invest 80,000 in a bank at 12% rate per year for 30 years then you know that you will get approximately 10,000 after every year for next 30 years. To be very precise in a fixed income you know what you will get after making an investment. In a non-fixed income investment you do not know with certainty what you will get after a specified period of time, you may even end up with less than what you invested. For example if you bought a land for 80,000 you do not know the price of that land after 30 years, it may be 500,000,800,000 or just 200,000. Similarly stock market investment is also a non-fixed income investment. However, the non-fixed income investment provides a much higher long term return as compared to fixed income investment.
BASIC RULE OF INVESTMENT:
The basic rule of investment is very simple; when you are young you should invest more of your “assets” in “Non-Fixed Income” investments because this type of investment can provide you with much higher returns. Since you are young and can wait and can also tolerate the ups and downs of your investment you should invest in these types of investments. However when you get older you should increase your investment in fixed income because now you have less time and ability to tolerate the ups and downs and when you eventually get retired you are entirely dependent on income stream and non- fixed income is not suitable for you because it doesn’t provide much income on a regular basis whereas you need income after every month.
WHAT IS HUMAN CAPITAL?
Suppose you are 30 year old and have saved 50,000 so far. You want to work for 30 more years and plan to save 10,000 per year. What is this 10,000? You will add this 10,000 to your portfolio of 50,000 every year and your portfolio will increase both by return and by this contribution of 10,000. You will be wondering where is Human Capital in this picture. The only asset that you have right know is 50,000 which you have invested some where. Actually there is a much bigger asset that you have and that asset is invested in fixed income i.e. it will provide you 10,000 every year for 30 more years. This is the income that you will get from your saving. Recall this is similar to my earlier bank example where you could have got 10,000 every year; the only difference is earlier you were investing “100,000” to get 10,000 per year and now you are working to get 10,000 per year. The present value of this asset is (I skip the detail of present value concept however understand it simply as the present value of you income stream) around 80,000 if we assume an interest rate of 12%. Put it simply, if you had 80,000 and invested that amount for 12% per year you would have got 10,000 per year. So this 80,000 is your human capital and your portfolio of 50,000 is your financial capital. So you total assets are:
Total Assets = Financial capital + Human capital = 50,000 + 80,000 = 130,000
You might argue that you do not have this 80,000 s0 how can you treat this as an asset. However this argument is false because you will surely get 10,000 per year for 30 years and that amount should be included to make your investment decision.
WHAT ARE THE IMPLICATIONS:
If you tell me that you are 30 years old and have a portfolio of 50,000 and have invested 60% of this portfolio in stock market/real estate then I would not be very impressed. Because majority of your assets are invested in fixed income and not non-fixed income which is more suitable for you as it provides much higher long term returns. Remember 80,000 of your asset is already invested in fixed income and 40% of your financial portfolio is also invested in fixed income which means 80,000 + 20,000 = 100,000 is invested in fixed income so actually 100,000/130,000 = 77% is invested in fixed income and just 23% in non-fixed income which is not that good for 30 years old young professional. The only solution is to invest more of your financial capital in non-fixed income, even if you invest all 50,000 in non fixed income it still means that only 50,000/130,000 = 38% is invested in non-fixed income, however this is better than earlier situation 38% is better than just 23% allocation.
RELATIONSHIP OF HUMAN AND FINANCIAL CAPITAL:
Just see the attached figure, as you get older you have less years to work and save which means your human capital (which is fixed income) as a proportion of total assets decreases which means you should invest more of you financial capital in fixed income and this is exactly what the “basic” rule of investment says.
However, please remember that I assumed in this analysis of Human Capital that you got a stable job and there is no great threat to your job and even if you lost your job you have an ability to find another one easily.
You can post a comment if you have any question or you can send me an email at firstname.lastname@example.org.