Monday, June 25, 2012

Second Look: Human Capital

Writing this blog has taught me a lot about personal finance and investing. This is one of a series of articles where I argue with my former self by disagreeing with one of my previous articles. Unlike politicians, I’m allowed to change my mind as I learn more from my readers and my own research.

In a post about human capital, which is the present value of your future earnings, I said
“Human capital is definitely a worthwhile concept in personal financial decisions.”
Back then my only real criticism was that human capital should take into account the cost of your basic needs for food, clothing, and shelter. With this caveat, I believed that taking human capital into account when making financial decisions was sensible. I’m much less positive about this idea now.

I think that for most people, there is great uncertainty in the total of future income. It’s easy to look back at your life and decide that your career was inevitable, but I doubt you thought this when you were young.

Comparing my career to my father’s is instructive. We had similar technical abilities, but his income was cut short by an adverse health event in his late 30s. If he had already spent some of his expected future high income, the result would have been a disaster. Fortunately for me, I’ve had no serious health problems. Looking at me back when I was 25, it turns out that my human capital was large, but my father’s human capital viewed from his 25th birthday turned out to be modest. These facts were not predictable when we were young.

My thinking now is that human capital is sufficiently uncertain that people should be very careful about borrowing against it. Borrowing for an education that gives good employment prospects is sensible, but borrowing against future income to upgrade your lifestyle is a dangerous game.

On the Positive Side …

Here are a few of my older articles that I still quite like:

The nature of competition in active investing is different from competition in other endeavours.

The impact of MERs on mutual fund returns.

MER drag on returns in pictures.

Many bank fees should be considered interest charges.

Conflicting views of debt.

Hot water heater: rent vs. buy.

Dihydrogen monoxide de-contamination to be costly for municipalities.


  1. Good post as usual. I think you make an excellent point. Agreed that some types of borrowing from your future earnings potential may be more prudent than others. I think delaying saving for retirement until later in one's working life or saving less because you plan to work well into your golden years may not be prudent. Buying a house based on your realistic earnings potential would be less concerning since you should be able to downsize or sell if your earnings potential changes for the worse.

  2. @Blitzer68: I agree that counting on being able to work late in life may not be prudent. Even if you're willing and able, your employer may not want you. Many people will be forced to work at lower-paying jobs in their retirement years.

    On the subject of homes, I think it all comes down to the definition of "realistic earnings potential." In general, buying a home is a good idea if you can afford it reasonably comfortably. I've never had mortgage payments + property taxes + heating add up to more than 22% of household income. I can't imagine going up to 30% or more.

  3. It seems your father experienced severe capital impairment, which of course can be protected against with insurance and that's the usual argument made by people like Moshe Milevsky. Despite the fact that human capital is risky, I'd still vote for it being a useful idea. Borrowing against one's own human capital entails the same leveraging risk as with any other investment doesn't it?

    Re your preamble: If only politicians did change their minds as they learned more ...

  4. @Canadian Investor: I'm not sure if there is a kind of insurance that would have paid off in my father's case. If it exists, it must be incredibly expensive.

    I'm not arguing that the concept of human capital isn't useful, but that it can't be summed up in a single number. The amount of human capital a person has gets drawn from a distribution with quite high volatility, particularly for young people. You can borrow against human capital, but it's high volatility places severe limits on how much leverage is sensible to use.

  5. Regarding your Dad's situation, disability insurance covers health events that affect the ability to earn income

    It is expensive, but not terribly so.

  6. @Mike: As I understand disability insurance, it guarantees some fraction of your current income if you meet some test of degree of disability. However, it won't give you the missed pay raises from failing to move up the corporate ladder. So, for a man in his thirties, disability insurance might replace a fraction of human capital, but most human capital would still be lost.