CFA III covers topics on private wealth management, with a chapter focusing on private clients (individual clients as opposed to institutional clients). One of the chapters I enjoyed learning about is on human capital vis-a-vis financial capital, of which the latter is what most people are more familiar with. That leads one to think about the Individual Balance Sheet vis-a-vis the Traditional Balance Sheet, which I find is quite similar to the things I’ve already done to track my finances. We start with some simple analogues of basic relationships between Net worth, Assets and Liabilities.
Total Wealth = Human Capital + Financial Capital
Net Worth = Total Wealth – Liabilities
Financial capital comprise of both tangible and intangible assets that are owned by the individual or a household. These include property, stocks and bonds, surrender value from insurance policies and even expected payouts from pension plans. Conceptually, one can think of future earnings or wages as a future interest or dividend payouts as a result of the individual’s skills, knowledge, experience – or in other words, human capital. Whether these are interest-like or dividend-like payouts depends on whether the kind of work one engages in is bond-like or equity-like respectively. By way of example, a teacher’s salary with relatively stable annual increments and low likelihood of retrenchment is more akin to the low-risk nature of holding on bonds. On the other hand, an entrepreneur who takes on the risk of setting up new businesses and may see returns from some ventures but not others will experience equity-like volatility and returns characteristics.
Correspondingly, in the interest of diversification, one should consider the implications of human capital on asset allocation and thus build their investment portfolio around it. In practice, what this means is that the teacher may wish to consider investing in the equity indexes to gain the necessary risk exposure for higher returns, while the entrepreneur balances out his unstable income with fixed deposits or investing in bonds. And if one’s compensation includes stock options, then all the more that other asset classes beyond equity should feature in one’s investment portfolio. Fundamentally, it means that the optimal asset allocation should consider the nature of one’s human capital and not just typical factors such as investment time horizon or the risk-return characteristics of asset classes.
Human capital is not fixed – One can improve on it through skills upgrading or leveraging on social capital and network to create value for themselves. Making a mid-career switch, while not easy, is also one way to change destiny. I reflected on this recently. Governments, including Singapore’s, recognise this and thus encourage lifelong learning as a way to ensure that individuals’ human capital remain current and even can be improved upon over time. And then there’s also side hustle, where apart from having an alternative income stream, one is also likely to pick up other skill sets beyond one’s day job.
However, very much like financial capital, human capital depreciates as well, and typically with age. In Singapore, the statistics are telling. Based on MOM’s Labour Force in Singapore 2021 report, Singapore’s labour force participation rate by age peaks at 93.4% in the 30-34 age group and median gross monthly income from work peaks at $5,958 in the 45-49 age group, suggesting that there is a smaller proportion of Singapore residents who work as they age, and of those that do, they earn less than younger residents. With rapidly changing demands of the workforce, those without the relevant skills are likely to be older, and they are less likely to be able to command a premium on their salary.
To that end, the main point of investing is to convert human capital into financial capital so as to fund retirement where human capital is virtually zero. At that point, proper management of financial capital and insurance coverage are crucial to ensure that one can retire in peace under most probable circumstances. In this light, my interpretation of FIRE is to arrive at a position that one has sufficient financial capital for sustenance, and has the option of not tapping on human capital (not working) if the individual does not want to.
I hope this important concept has given some food for thought. We will discuss more about human capital valuation in another post.
Making Cents 