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Posted: July 20, 2009

You are your portfolio’s most valuable asset

How to weigh your "human capital" when investing

Wayne Farlow

Your largest single asset is likely to be your ability to generate earned income. This asset is commonly call “human capital.” When we are determining appropriate asset allocations for our investment portfolios, it is important to include the human capital asset. Let’s look at some ways that human capital could change your approach to allocating other assets in your investment portfolio.

There are three major components of human capital. These include:
1) your annual income from work, 2) the number of years remaining to work and 3) the variability of your annual earned income. Variability can be fairly large if your income is based on commissions. It also can be large if you have a job from which you may be furloughed or laid off when economic conditions deteriorate.

Let’s look at three occupations to demonstrate how human capital can be included in asset allocation decisions.

Tenured professors

There are few professions more secure than that of a tenured professor.  Their annual income has historically been very predictable, with the main variance being additional income generated by consulting, research or publishing. Thus, a tenured professor’s income is very similar to the yield from a high-quality bond.

Since there is little variance of annual income, younger professors should typically have higher asset allocations in riskier assets, such as equities and alternative investments. As a professor approaches retirement, with a decreasing number of remaining work years, the amount of riskier assets should also decrease.

Real estate brokers

Real estate brokers receive most, if not all of their income from commissions. While established brokers have some expectations about annual income, their income is highly variable, depending on housing market conditions and interest rates, among other factors. While a Realtor can often work for as long as they wish, the variability of income makes their human capital asset very similar to equities (stocks).

If you are a Realtor, you might be better served by having a greater portion of your investable assets in fixed-income (bond) investments. This will make your investment portfolio more stable as your income varies. Stable investment income can be very beneficial in lower-earning years, which often occur when the stock market is also in decline.

Entrepreneurs

If you work for an entrepreneurial company, both your income and the number of years that your income will continue are variable. In down years, entrepreneurial companies are typically the first to cut salaries and benefits as well as to have layoffs. Having worked most of my life as a “high-tech” entrepreneur, I am very familiar with the “bipolar” nature of many entrepreneurial companies. As an entrepreneur, your human capital is similar to microcap stocks and commodities, either going up dramatically or dropping to $0.

Not only should an entrepreneur have higher-than-normal fixed income positions in their investment portfolio, they should only buy equities in relatively risk-free companies.

Entrepreneurs have their human capital linked to the success of their companies, which are typically small and highly vulnerable. It is important that they take fewer risks in their investment portfolios to offset the high risk of their human capital.

While you may not work in one of these three occupations, your human capital will likely have some characteristics of one or more of these. When you and/or your financial adviser are developing your asset allocations, be sure to consider your human capital as an asset that can compliment your other financial assets.

Regardless of your type of human capital, it can always be terminated by death or disability. Life and disability insurance need to be a central component of any financial plan. Properly constructed, they will provide the funds required for you and your family, if you are no longer able to contribute the expected human capital.

Human capital is an asset that should not be ignored. Including your human capital when allocating your investment portfolio can help you choose the amount of risk that is most appropriate for you and your family. 
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Wayne Farlow is the founder of Financial Abundance, LLC, a Registered Investment Advisor firm.  He is a Certified Financial Planner (CFP®), focusing on Retirement Planning, Investment Management, Small Business Owner Planning and Sudden Wealth/Inheritance Planning.  His book, “Financial Abundance Guide,” is available free at www.farlowfinancial.com .  He can be reached at wayne@farlowfinancial.com or at 303-554-0309.

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