Wednesday, August 11, 2010

Human Capital

The concept of human capital is an interesting one. A young person may have no significant assets other than the potential to earn money over his or her lifetime. This potential is called human capital. Over time, we turn our human capital into actual assets.

Moshe Milevsky does a good job explaining the idea of human capital in his book, Your Money Milestones. He gets his students to create a personal balance sheet. The first versions they produce are usually depressing; they are full of student loans and few assets. Then he teaches them about human capital. They work out their expected income over their working lives and add that to the balance sheet. Presto! Now they are millionaires.

Human capital is definitely a worthwhile concept in personal financial decisions. However, it is misleading to include future income without considering future needs. We all need water, food, clothing, and shelter. Even the most basic versions of these things have a cost. Nobody wants to end up old and alone eating cat food.

A lifetime of these basic costs should be included in any balance sheet that includes human capital. Without considering lifetime basic costs and the consequences of not having enough money to maintain a minimum standard of living, people may be enticed into taking too much risk.

An example of taking too much risk is Milevsky’s smoothing of consumption over a lifetime. By considering human capital without thinking about future basic human needs, young people may be enticed into excessive consumption that risks their futures. Most young people don’t need more reasons to spend money.

5 comments:

  1. Very interesting concept. I was intrigued be what you had to say and turning Human Capital in to actual assets.

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  2. I'm skeptical about this whole concept. This is similar to leisure time: I doubt there's any useful way to put a single number on the value of your human capital.

    Not only do you need to estimate your future costs, but you also need to allow for the time value of money. The most meaningful question to answer would be "what lump sum of cash now is equivalent in value to my human capital?" I'm not sure there is any meaningful answer to that.

    It is possible to diversify across many dimensions (market segments, companies, asset types, etc). However, time is unlike any of these other dimensions. There's an inherent asymmetry to time (the past is certain and unchangeable; the future is uncertain and changeable). Milevsky's concept of taking on lots of market risk when you're young is speculation pure and simple.

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  3. @Patrick: I agree that it is challenging to define human capital as a specific number for a given person. Human capital actually has some probability distribution. However, this value is not zero and it makes sense to try to take human capital into account when making investment and consumption decisions.

    However, the wide range of possible values of human capital for a given person speaks to the risk that you mention. I agree with you that overconsumption when young is a form of speculation.

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  4. Michael
    If you look at the personal balance sheet on page 5 of Moshe Milevsky’s book, there is an entry labeled “estimated hidden liabilities” in the Liabilities column. It could probably be explained better, but this is where he told me (several months ago) he represents those future costs of food, water, shelter etc.

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  5. @Larry: Thanks for the explanation. It would have been nice to have that explanation in the book if that's what he intended "estimated hidden liabilities" to mean. The chances of someone getting that from the book are just about zero.

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