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Most people calculate their net worth by adding up tangible assets such as stocks, bonds and real estate. But there’s an important element that many forget to factor into the wealth equation: human capital, which is another way of saying your future earning power.
Business owners and managers are already familiar with the concept of human capital, and see it as an integral part of the growth of their business, and thus, their wealth. Individuals might think about the consequences of losing their future income when considering disability or life insurance, but otherwise, it’s generally sidelined when planning retirement.
But depending on how far you are from retirement, 10 to 40 years of future income can have a big impact on your wealth, and might even act as a hedge against your financial portfolio during economic downturns. For example, if your job is in real-estate construction and you were laid off as a result of the housing market collapse, then your earning power is directly correlated with the performance of the real estate market, meaning you'll suffer when it suffers, and do well when it performs. Another example is if you have all your financial assets tied up in company stock where you work. Sure, it’s fun during the boom times, but financial planners usually advise against having assets that all move in tandem to avoid huge losses when things turn ugly.
If, on the other hand, your career is in medicine, you probably enjoyed a stable income during the real estate bust. So in that way, you’ve hedged your financial portfolio by maintaining an income during a financial sector downturn, and avoided having to dip into savings.
Obviously, having a career correlated to an economically-sensitive industry is not always controllable, and if you're a business owner, you may need to keep most of your money tied up in your business. What counts is that you know whether your future earning power is directly related to the performance of your financial portfolio, and factor it into a comprehensive financial plan. If your income is rock-steady, perhaps you can invest a larger part of your portfolio in riskier assets for more growth (depending on your time horizon and risk tolerance), or you can invest more conservatively if your income is driven by economic swings.
Have you taken your human capital into account when planning your financial future?
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