Human capital

From Bogleheads
Jump to: navigation, search

Economists use the term human capital to describe the present value of future labor income.[1]

Young investors typically have much more human capital than financial capital (the value of their savings and investments). Considering human capital as bond-like enables young investors to take more risk by allocating more of their portfolio to stocks. Younger investors have many years to transform part of their human capital into financial assets by saving and investing. They also have more opportunities to use the savings generated by their human capital to buy stocks when prices decline.

Older investors have less bond-like human capital, and therefore cannot afford the risk of higher equity allocations. They have less time to transform their human capital into financial assets; i.e., less time to earn, save, invest, and take advantage of stock market declines.

Human capital defined

Economists use the term human capital to describe the present value of future labor income.

Labor income is the income earned from labor; e.g., job income or salary.

Present value [2], as it applies to human capital, is today's value of future income, discounted by an assumed interest rate (discount rate).[3] The discount rate depends on the time value of money.[4]

A common investing guideline is to decrease the portfolio's ratio of equity securities (stocks) to debt securities (cash and bonds) as one ages. The rule of thumb of holding one's "age in bonds" is an example. One rational for this is that human capital can be thought of as an inflation-indexed bond.[5]

Example

For example, assume a constant, after-tax, real (inflation adjusted) annual labor income of $100,000. At a real interest rate of 0%, the human capital represented by 30 years of this future labor income is $100,000 x 30 = $3,000,000. At higher real interest rates, the present value of the future income is less, since it must be discounted by the real interest rate:

  • Using a real discount rate of 3%, the present value of annual income one year from now is $100,000 ÷ 1.03 = $97,087.
  • The present value of cumulative annual income two years from now is $97,087 + ($97,087 ÷ 1.03) = $191,347.
  • The present value of 30 years of this future real income, discounted at a real rate of 3%, is $1,960,044.


See also

References

  1. Bodie, Merton (2000). Finance. Prentice-Hall. p. 146. ISBN 978-0133108972.
  2. Present value, including tutorials using Excel, is discussed in Comparing investments.
  3. Discounting translates the future income amount to an equivalent amount of income today.
  4. Time Value of Money (cash flows and financial variables) is discussed in Comparing Investments.
  5. Bernstein, William (2010). The Investor's Manifesto. John Wiley & Sons, Inc. p. 76. ISBN 978-0470505144.

Further reading

External links