Edition 43, Finance

Human Capital, Financial Capital and Investor’s Life Cycle

By: Renata Herrerías
CFA

Saving is the opposite of consumption. We save so that we can consume more in the future or at least consume the same amount as we do today. For example, the objective of the pension systems around the world is to ensure that people, at the time of their retirement, can replace their labor income with the resources saved during their working years. This means that the wealth they generated during the years they worked should be enough to support them throughout their entire life.

What constitutes a person’s wealth? What does it mean to optimize a person’s wealth? How do you optimize the distribution of labor wealth? What factors have to be taken into account in this optimization? This has been a subject of continuous study in modern finance and is a key issue for governments, especially in countries where young people used to pay for the retirement of the elderly and where the number of retirees is growing in proportion to the economically active population. The discussion has many aspects of great importance: from the amount of the contribution to the retirement savings and the administration of the resources provided, to the best way to deliver the resources at the time of retirement. Each part of the process is essential to ensure that a person can be economically independent until the day of his/her death. The concept of distributing a person’s wealth throughout their life is known as life-cycle finance.

Personal wealth = financial capital + human capital

It is easy to forget that the wealth of an individual is not only limited to the financial resources they have, whether it be money or liquid assets, such as real estate, or financial assets. A key component of a person’s wealth is their potential to obtain revenue from the hours she worked. This is what is known in economics as a person’s “human capital.” When we are young, our principal asset is our ability to work and the potential that we have to generate revenue throughout our working lives. At the beginning of our career, our financial wealth is very low compared to the value of our human capital. As time passes, the value of human capital decreases, while financial wealth increases. The years of education and the accumulation of knowledge increases a person’s human capital simply because the probability of generating higher income also increases. It is well known that increasing human capital in a society translates into greater economic wealth and greater well being for the general population.

The value of human capital is a commodity that is subject to risks that sometimes are much greater than the risks of a financial investment. The possibility of unemployment, the instability in labor income, the inability to continue working or even death harms the income generation and consequently decrease the value of human capital. If when we make investment decisions we consider the risks to which financial instruments are subjected, why don’t we also see the risks of human capital if it is also part of our wealth? The simple consideration of the value of human capital and its risks drastically changes the way we make our financial decisions. For example, buying life insurance is a way to protect our human capital against the risk of death, especially when there are others who are economically dependent on this capital.

Life cycle and design of the investment portfolio

Markowitz’s modern portfolio theory introduced the idea about the optimal balance between risk and return that an investment portfolio should have. Investment portfolios are formed by setting an “optimal” combination of assets that maximizes the return for the investor given her risk tolerance or rather, that minimizes the risk given a certain return objective. However, this framework does not take into account the risk factors of human capital of an investor nor much less her current stage of life. In fact, Markowitz is a static model, without considerations of optimization with the passage of time. From a financial point of view, an individual’s life can be divided into three stages: 1) growing and training stage, 2) the stage of accumulation of wealth, and 3) the retirement stage. To maximize our wealth, decisions on savings and consumption should take into consideration the three stages and not focus, as we usually do, only on the accumulation stage.

In 1992, Robert Merton, Zvi Bodie and William Samuelson proposed a new portfolio model in which human capital is considered for the first time. The design of an investment strategy for a person, in addition to taking into account their predilections of risk and return, should include factors like the preferences of savings and consumption as well as the balance between free time and the number of hours worked in each moment of their life cycle.

Investment decisions should not be static, i.e. they must not only consider the current situation of the investor and their short-term goals, but also long-term goals. People have different investment horizons, according to the moment in their lives. The investment portfolio should maximize the wealth of the investor in such a way that will optimize the use of such wealth over the investor’s entire life. This is what in economics is known as “to maximize the expected utility of wealth.” The main contribution of the Merton, Bodie and Samuelson model was to explain why a young person, with greater flexibility in their working life, can take many more risks with their financial portfolio than an old person. The wealth of young people is composed mainly of their human capital, while their financial capital is small in proportion. Given a certain tolerance for risk, if the human capital has few risks and there is flexibility, then you can take more risks in the portfolio of financial assets.

Risks of human capital

As we said, human capital is not an asset without risks. In each stage of life, you run into risks and some can be decreased or eliminated. For example, during the accumulation stage, an important risk is death, which mainly affects workers who have economic dependents. The mechanism to cover this risk is with life insurance. Another risk in the accumulation stage is the possibility of losing your job or the possibility of a decrease in your salary, which generally there are no mechanisms to cover them. In some countries there is unemployment insurance or, as part of their social security programs, workers receive support while they are unemployed, but the resources provided only meet consumption needs and are not enough for any kind of saving. The best way to reduce the risk inherent to income is to save more; in this way, if the income decreases there will be more financial wealth. On the other hand, when the amount of financial wealth is greater, there is a greater possibility of accumulating income, i.e., the positive effect is multiplied because of compounding returns. A greater interest rate in the early stages of the accumulation stage allows more time for the financial capital to increase.

Finally, during the retirement stage or final phase of the life cycle, the main risk is that of longevity; i.e., the possibility that personal savings become exhausted and do not cover all the years of retirement. There is no doubt that better planning and higher rates of savings during the accumulation period lowers the risk of longevity. However, it is important to think about other mechanisms to reduce it. One way is to buy an annuity that delivers periodic payments to the worker all the years of his life after retirement. The money saved is exchanged for an annuity that is paid on a regular basis until the person dies.

The traditional view and time diversification

Erroneously, we think that a young person can tolerate a higher risk on their financial wealth because the long-term investment horizon would allow him to recover from significant losses. This idea is known as “time diversification.” However, the risk of a catastrophic event increases with time. If the investment horizon is quite long, the possibility of a financial crisis, like the one in 2008, increases significantly. In reality, what the long-term horizon allows is greater time to reconstruct financial wealth when losses occur or, in other words, there is more human capital to offset losses in financial capital. That is why young people whose human capital has a lower risk in the early stages can take greater risks with their portfolio of financial assets.

The complete scope

The decisions on when and how much to save should be made considering that human capital is another one more of our assets. Decisions should not ignore our stage in life and our earnings potential. A worker in the automotive industry would be ill advised to invest his financial capital in debt securities or capital in companies belonging to the same area. A person without a steady job or without fixed, periodic and secured income should not take risks in his investment portfolio. On the other hand, any person with a fixed-term contract and defined salary with constant growth rates should put their savings in riskier instruments and with the greatest potential for return.

It is essential not to lose sight of the fact that decisions made today will have a significant impact on the amount of accumulated financial wealth for retirement. Whatever our saving or consumption preferences may be, the best decision is to distribute our wealth throughout our lifetime.?

References

Bodie, Z., 2003, “Thoughts on the Future: Life-Cycle Investing in Theory and Practice”, Financial Analysts Journal, enero-febrero.

Bodie, Z., Merton, R.C. y Samuelson, W., 1992, “Labor supply flexibility and portfolio choice in a life cycle model”, Journal of Economics Dynamics and Control, 16, 427-449,

Ibbotson, R.G., Milevsky, M. A., Chen, P. y Kevin X. Zhu, K. X., 2007, Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance, CFA Institute, Research Foundation.

Post a Comment

Your email is never published nor shared. Required fields are marked *

*
*

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>