BBC Capital

Riskology

The financial risk you don’t even know you’re taking

About the author

Ari has written about financial products and investing for The Wall Street Journal, Forbes, and Pensions & Investments. Find him on Twitter.  

(Harley Schwadron)

(Harley Schwadron)

How much are you worth?

No. Really. Between your job and what you contribute to society, how valuable are you? Many ponder the question, but even after reams of studies and philosophy courses, it is difficult to pin down a way to define your personal value.

Instead, we rely on an abstract term, something that academics like to call “human capital.” Yet, it is worth taking the time to understand your human capital, along with its potential and limitations, since it can be a very useful tool for assessing and balancing your financial risks.

At its simplest, human capital is the asset that you, personally, bring to the table every day. It’s the embodiment of your potential to earn income. It can be risky and short-lived (think of an athlete’s career) or staid and predictable (such as a tenured professor).

Why does your human capital matter? When you have a sense of the worth of your personal effort and life’s work, you can plan smarter and take steps to avoid or lessen major risks in the way you invest or spend your money. Here’s the trick, though, to avoid financial quicksand: we must consider not only our personal value now, but also how we are likely to grow and change.

Consider the case of a highly-specialised lawyer. During the dot-com boom of the late 1990s, his practice hummed as he took young tech companies public. At the same time, he used his knowledge of the tech industry to invest personally in high-flying tech stocks, rather than setting some cash aside for investing in other industries. But when the deals dried up in the dot-com bust, his primary business suffered and the investments tanked as well. 

The moral: don't mix your career with your financial assets and take the long view. Our lawyer would have been better off if he had considered the trajectory of his own career and expertise over the next 20 years — that is, his own human capital.

“Looking at current and future work income, and even pensions or social security, can help you think about your total wealth,” in terms of your career and its value, said David Blanchett, head of retirement research for Morningstar’s Chicago-based investment management group.

Breaking it down

Like any asset, human capital should be considered first on its own and then in relation to your overall finances.

Consider these other examples of poor human capital-to-financial asset diversification: doctors who invest in drug companies, on the notion that their expertise gives them insight into the success of a new treatment; technology employees who think they have a bead on what’s next; or real estate pros that can’t get enough, well, real estate.

In these cases, it might seem clear — investing your money into the career or field where your source of income (and thus, your investment dollars) is derived might not be so wise.

But, often, we don’t think much about it. Just ask the former employees of Enron.  That financial tragedy is a now-classic example that blindsided thousands of people who may not have realised the link between their human capital and financial assets.

The 2001 bankruptcy of the Houston, Texas-based energy firm destroyed the savings of thousands of employees who had invested much of their retirement account directly in company stock. Foolish in hindsight, the booming energy giant offered employees company stock in its retirement plan. At the time, it seemed like a no-brainer investment choice due to the positive returns from the firm and growing worldwide demand for energy. Yet when the company collapsed, so did employee retirement savings.

Consider this

Morningstar’s Blanchett poses a few questions to consider: How risky is your human capital? Do you work in a profession or industry that is highly volatile or susceptible to economic cycles? Are your skills up-to-date or do you face obsolescence? Should you invest in education to improve your value? How correlated is your career or income to your financial assets? Are you diversified (do you want to be?) And, is there an underlying exposure to your human capital that you are not thinking about, a particular geography, sector or technology, for example?

Entrepreneurs and business owners, in particular, need to understand human capital and where biases can get in the way of sound financial decision making. That’s because these individuals are so fully invested in their occupation that their human capital and financial assets are intertwined.

Sometimes that means taking what many might view as extreme precaution. Consider the case of farmers.

“We’re surrounded by farmland in the Midwest — and farmers understand this concept,” said Don Grant, a financial planner at Carey, Thomas, Hoover and Breault in Wichita, Kansas. “They take tremendous risk with their primary source of income — growing wheat—but when they invest, they traditionally stick to certificates of deposit and US Treasury bonds.”

Such financial assets offer steady, predictable returns with little risk or loss of principal, unlike the ups and downs of a commodity like wheat or corn, where monthly or annual cash flows is linked to weather and global demand.

The same is often true for those in high finance. With careers so interwoven with the volatile stock market, financial professionals’ assets lean to the safer side.

It’s important to constantly seek to expand your human capital. Think of it as a form of investment.

“Here is where most people fail,” said Robert Pagliarini of Pacifica Wealth Advisors in Mission Viejo, California. “They spend years of their lives increasing their human capital through school and college and then they get a job and forget all about learning, growing, and expanding their skills.”

“This is a colossal mistake,” he adds.

So, the next time you take a look at your assets—quarterly, annually or when you pay your taxes—take the time to evaluate your human capital: the most important asset.

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It’s important to constantly seek to expand your human capital. Think of it as a form of investment.