Diversification is one of the most basic principles of investing. Our common understanding of it, however, typically overlooks an investors' largest asset – the value derived from one's profession, commonly known as "human capital".
Economists define human capital as the actuarial present value of our earnings or wages over a lifetime. For most individual investors, human capital dwarfs financial capital. In the United States, for example, it represents 90% of total assets (including home equity and private businesses) for investors under 30 years of age (see Figure 1). As an investor’s career progresses, human capital transforms into financial capital through savings. Even for investors in their 50s, human capital still oftentimes represents at least half of total wealth.
Figure 1: Magnitude of Human Capital
Source: Kyrychenko, Vladyslav, 2008, “Optimal Asset Allocation in the Presence of Nonfinancial Assets”. Financial Services Review, vol. 17, no.1 (Spring): 69-86.
Because the importance of human capital increases with schooling, per capita GDP, and life spans, countries with high human development in these areas have relatively large reserves of human capital. In the Middle East, for example, countries like the United Arab Emirates, Qatar, Bahrain, and Kuwait have a higher population-weighted average human development index than Europe, according to the United Nation’s 2010 Human Development Report. They rank particularly high in educational development (e.g., adult literacy, years of schooling), which has expanded more quickly in the Middle East than in Europe.
Human capital is fundamentally different from financial capital. For one thing, it is not easily converted to cash. One cannot immediately sell these cash flows in the marketplace. They must be realized over time. Second, earnings derived from one’s employment prospects or entrepreneurial endeavors are often tied to the fortunes of a particular sector or industry, which creates a concentrated comprehensive portfolio that is not always easily diversified.
The Nature of Human Capital
Estimating the magnitude of an individual’s human capital requires identifying the cash flows derived from one’s profession and estimating a growth rate. It also requires one to determine whether the volatility of those cash flows is more bond-like or more stock-like. For a tenured university professor, human capital is more bond-like. For an investment banker, it is more like a volatile stock.
To understand its influence on portfolio management, we also need to understand how our human capital is correlated with the overall market. The investment banker’s human capital, for example, is likely to be impaired at exactly the same time that market values of other assets decline. A high correlation with the overall market provides little diversification risk-reducing benefit for the larger comprehensive portfolio.
An industry-specific or firm-specific skills set is also riskier than a transferrable one. An investment banker, for example, may have more difficulty replacing his income stream in an industry downturn than a human-resources professional who can transcend industry or sector boundaries.
Finally, the ease or flexibility with which one can leave and re-enter the work force is important. Human capital is relatively less valuable if external factors, such as political instability, health concerns, market performance, or employer whims determine retirement timing.
Implications for Portfolio Management
Perhaps the most obvious and profound portfolio management insight is that a portfolio that appears diversified in relation to one’s financial assets may be highly concentrated in the context of one’s life balance sheet, which incorporates human capital. Suppose, for example, the income and employment prospects of the young executive are derived from petrochemical manufacturing in Saudi Arabia. The value of that net employment capital depends heavily on the state of the price of petroleum products. A traditionally diversified or indexed “market” portfolio that includes additional exposure to oil-sensitive stocks exacerbates this already-concentrated position.
Figure 2: Hypothetical Example of a Young Executive’s Life Balance Sheet
Executives of Saudi Arabian petrochemical manufacturers might ameliorate this situation by excluding petroleum–sensitive assets from their portfolios or over-weight assets that are uncorrelated or negatively correlated with petroleum prices. Investors who are particularly concerned about their human capital risks might even use sector or industry ETFs to hedge their human capital. By shorting an ETF that tracks returns to companies in the industry in which they work or investing in an inverse ETF that tracks the same industry, investors can hedge some or all of their human capital exposure.
Conclusion
By their very nature, Middle Eastern corporate executives have concentrated positions in the companies they manage. By recognizing that a large part of their “portfolio” is human capital, they can identify, diversify, and even hedge some of these risks. Analyzing this broader portfolio is likely to suggest that a domestically or even an internationally indexed portfolio will not provide maximum diversification benefits. Rather, a diversified portfolio is unique to each individual.
Click here to read the article as published in Arab Times
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