Human vs. Financial Capital
Our financial capital is the total of our saved assets, beyond the value of the home where we intend to reside in retirement.
Human capital is the present value of all future earnings. It is our health, knowledge, skills, and motivation. Anything we do to increase our ability to earn a higher future income is an investment in human capital. It's at its peak around age 25 and mostly gone by age 65.
At best, we have about 40 years to convert enough human capital into financial capital to last the rest of our lives.
In the graph, the horizontal axis is in years (from 25 to 65), and the vertical axis is in dollars (from zero to $1.4M). For a larger view, just click on the graph. The black line represents increasing financial capital, and the yellow line represents decreasing human capital. The red line, labeled Total Capital, is the sum of the other two lines. In this example, total capital increases because the person successfully converted human capital to financial capital. (Click on the drawing to enlarge it.)
Our human capital decreases and eventually stops. In retirement, if the returns from our financial capital fail to cover our living expenses, we must "spend down" our financial capital. Hopefully, we have enough financial capital to last our entire lifetime. Some retirees have enough financial capital that their retirement returns exceed their living expenses, so their financial capital continues growing indefinitely.
You may wonder why I placed this web page in the Asset Allocation section of this site. The reason: Human capital usually functions as a bond. Financial planners understand that young adults have this large "human capital bond" so they encourage the young worker to hold a high percentage of their financial investments in stocks, which grow faster over this long time horizon. These planners advise older workers to shift money from stocks to bonds in order to compensate for their diminishing "human capital bond."
There is a seldom recognized caveat to how our career should impact our asset allocation. To understand it, ask yourself, "Am I a bond or a stock?" In other words, does my career make my human capital function more like a bond or stock? If I am in an average job, or one more stable such as a school teacher, post office worker, or a tenured professor, then my human capital does act like a bond, and the traditional asset allocation strategy (see Asset Application Basics) applies.
But if my career is in high tech or is commission-based or cycles with the overall economy, then my human capital acts more like a stock. In this case, I should tilt my asset allocation more toward bonds than the traditional advice suggests. The worst scenario occurs when my human capital and my financial capital correlate. If they do, they will plummet simultaneously - a very scary scenario!
So, factor your human capital into your asset allocation. For more, read Asset Allocation Basics.
All the best, Tim