Navigating Risks: Mastering the Shift from Human to Financial Capital

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Continuing from our previous exploration in Hidden Riches: The Untapped Wealth of Your Human Capital, this blog will delve deeper into the risks to the strategic conversion of Human Capital into Financial Capital. For a comprehensive understanding, I strongly advise revisiting the earlier post before proceeding.

In our financial journey, we’ve established that an individual’s wealth comprises two primary components: human and financial capital. Over the course of our lives, we witness a gradual change from one to the other. But the pivotal question remains: how do we adeptly navigate and manage this transition?

Let us consider several critical factors that must inform our investment decisions:

• Human Capital Risk
• Portfolio Concentration Risk
• Wage Earnings Risk
• Mortality Risk
• Longevity Risk

Human Capital Risk
Human Capital is a cornerstone of our wealth journey. To mitigate risks associated with it, we should seek to diversify with suitable types of financial capital. Generally, human capital carries lower risk compared to common stocks, prompting a strategic tilt towards equities in our financial portfolio early in our careers. As the balance shifts from human to financial capital with age, we should progressively adopt a more conservative stance with our investments, as they will come to represent the bulk of our wealth.

It is not prudent to advise portfolio allocations without factoring in human capital. To reduce risk effectively, financial assets should be diversified in conjunction with human capital assets. The interplay between the risk and return profiles of human capital—such as wage and salary trajectories—and portfolio construction for individual investors is well-recognized among scholars and practitioners.

The most prudent investment strategy for individuals is to allocate financial wealth into assets that exhibit low correlation with their human capital, thereby maximizing diversification benefits across the entire portfolio.

Portfolio Concentration Risk
The adage about not putting all your eggs in one basket is more than just folk wisdom—it encapsulates the dangers of “concentration risk” in investing. This risk manifests as potential financial loss stemming from an overcommitment to a singular investment, asset class, or market segment relative to the totality of your portfolio.

This principle extends to our overall wealth, a blend of Human and Financial Capital. The catastrophic losses suffered by employees of Enron Corporation and WorldCom exemplify the dire consequences of poor diversification. Their incomes (Human Capital) and investments (Financial Capital) were tethered to their employer’s stock, resulting in simultaneous and significant losses across both forms of capital when their companies imploded.

Wage Risk
To combat wage earnings risk, a straightforward approach is to augment savings. This accelerates the conversion from human to financial capital and allows the latter a more extended period to benefit from compound growth, significantly enhancing its value by retirement.

Mortality Risk
The importance of Human Capital necessitates its protection. Mortality risk—the potential loss of human capital due to a worker’s premature death—can wreak havoc on a family’s financial stability. Life insurance is a time-honored instrument to shield against this risk, with higher human capital values typically driving greater life insurance coverage.

Longevity Risk
Post-retirement, we encounter a different form of risk. As retirees often draw more from their financial capital than their income can replenish, there’s a tangible threat of depleting our financial reserves. This “longevity risk“- the financial peril of outliving our resources – can be offset through annuities. These products guarantee a yearly income for life, allowing those with adequate means to secure annuities and ensure they do not outlive their wealth.

Summary
It is important to understand and manage this transition through various stages— from the initial accumulation of wealth in our working years to the eventual reliance on financial capital in retirement. During this transition there is a need for individualized investment strategies that take into account the unique interplay between an investor’s human and financial capital to ensure a secure and prosperous financial future.