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How Smart Investors Factor in Themselves as an Asset

Human Capital Factors Portfolio Management Risk Management

Connecting Your Career with Your Financial Capital

Part 2: Your Human Capital as an Investment

Welcome back to our multipart series on how to balance your human and financial capital risks and rewards. In our last post, we defined your human capital – i.e., your career – as an important source of the income you bring to the investment table, as well as an “asset” in its own rights, to be factored into your overall investment plans.

Today, we’ll describe several smart, but often-overlooked strategies for integrating your human capital into the rest of your investment decisions.

Consider the human capital of a highly entrepreneurial professional. For example, say you’re the managing partner of your own boutique law firm, a private equity real estate manager, or a manufacturing company owner.

Your Career Path and Your Risk

How do your professional challenges and opportunities relate to the rest of your wealth? For starters, your career path and risks are very different from those of a typical employee; your financial risks are also heightened compared to someone with a dependable salary.  

Often, you’ll have purposely dedicated most of your wealth into building your business, hoping to be more handsomely rewarded in the end. In fact, many successful entrepreneurs have leveraged their business to generate more satisfying financial and personal outcomes compared to being an employee. To name a few possibilities:

  • Enhanced wealth: You can generate a superior rate of return on your time and money by reaping all three sources of entrepreneurial rewards: earning an income, taking ownership distributions on company earnings, and building long-term equity in your business.
  • More control over your career: You can expect a longer duration in the business compared to an employee. As you succeed, you can decide when you’re ready to shift your role from being the hard charging, do-everything business owner to continue employment and ownership, but in the less-demanding position of consultant or learned mentor.
  • Greater tax efficiencies: Business owners also can enjoy extra tax benefits especially in the wake of the Tax Cuts and Jobs Act of 2017. As a business owner, tax deductions can reduce your effective tax rate, plus you aren’t taxed on the increases in the enterprise value of the firm until you sell.
  • Building something of value: As an employee, once you’re done, you’re done. Owning your own business can provide a better exit strategy, allowing you to not only capture a lifetime of cash flows, but also to potentially capitalize your business’ future earnings by selling the firm when the time is right.

In short, you’ve willingly taken on the higher human capital risks, hoping to earn these sorts of higher expected rewards. Of course, the reverse can happen too – and you know it. You could experience a far more spectacular crash, should things go wrong.

This brings us to our next point, which is the necessity to temper your high-risk career ventures with appropriate risk management. For example, you’ll likely want to have extra reserves set aside personally and professionally, as well as solid disability insurance to protect your most valuable asset: your future human capital.

Then there are your personal investments …

Managing the Unmanageable Risks

Come what may in your business ventures, a best practice for preserving your personal wealth is to harness the powers of diversification and asset allocation in your investment portfolio. But, while it’s common to consider your personal and business planning in isolation, you’re actually best served by blending them within your planning mix.

Family Inc.A mindset shift is necessary to see just how much your human capital plays into your lifetime wealth and your personal investing portfolio. We look to Douglas P. McCormick’s book, “Family Inc.: Using Business Principles to Maximize Your Family’s Wealth,” to provide a framework for thinking about long-term financial prosperity. McCormick rightly counsels for us to evaluate our labor as part of the “business” of being a successful individual or family. Most investors adopt a framework involving an allocation across a few tried and true asset classes like equities, real estate and bonds. “Family Inc.” posits this approach ignores the important component of future wealth, especially the value of one’s lifetime income.

BAM ALLIANCE’s Larry Swedroe offers excellent insights on planning for human capital as an integral component of your wealth. In a CBS MoneyWatch article, “Consider your human capital,” Swedroe explains:

Larry Swedroe"Not only do we need to define the magnitude of one’s human capital, but we also need to consider its variability. Some businesses and professions are highly cyclical, and are thus highly correlated to the economic cycle and the risks of owning stocks. Good examples of professions that might fall into the high correlation category are automobile and construction workers. Other professions have very stable incomes as their ability to generate income has little or no correlation to the economic cycle. Good examples of occupations that might fall into the low correlation category are health care professionals and tenured professors."

Entrepreneurial and other high-energy professional careers are often highly correlated with stock market and economic downturns. In other words, when the markets and/or economy plummet, odds are both your investment portfolio and your career earning power may be tanking in tandem.

The solution is to offset your human capital risks with an investment portfolio that’s been customized to lower these usual correlations. Again, Swedroe explains:

"Since one of the keys to properly constructing a portfolio is to own assets with low correlation, all other things being equal, investors whose intellectual capital is highly correlated to the economic cycle should consider taking less equity risk than those whose intellectual capital has low correlation to equity risks."

Managing your human and financial capital risks and rewards in tandem may sound great in theory. But how do you translate these principles into practical portfolio action? We’ll tackle that in our next post. Sign up to receive our monthly Cogent Advice newsletter and we’ll notify you as soon as that’s available.

Read Part 1: What's Your Human Capital Worth to You?

LEARN THE WORTH OF YOUR HUMAN CAPITAL

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