Human and Financial Capital

An investor’s total wealth is composed of both human capital and financial capital. Human capital (HC) is the discounted present value of expected future labor income. 

Valuing human capital is analogous to valuing a stock or bond. Value is the discounted PV of future cash flows. The discount rate applied to the future cash flows is related to the riskiness of the cash flows. Higher risk employment requires a higher discount rate and all else the same reduces the value of the HC.

HC can only be estimated. The estimate requires multiple assumptions: projected future earnings and their real rate of growth, mortality rates to determine the probability the earnings will be realized, real and nominal risk-free discount rates, plus appropriate risk premiums to add to the real discount rate.

Financial capital (FC) is the sum of all the other assets of an individual. This includes financial items such as stocks, bonds, and alternative investments as well as personal items such as a home, car, and other physical assets.

Financial capital is the value of all other assets owned by the individual. It includes current assets such as money market assets that may be consumed within the next year, personal assets such as a car or furniture that are likely to be consumed over time, and investment assets that may appreciate over time.

Investment assets include both publicly traded marketable assets, which are relatively easy to value, and non-publicly traded. The later include:

  • Real estate (other than publicly traded REITs). A home is often an individual’s largest single asset and may also be highly leveraged. If leveraged with recourse, default on the loan allows the lender to claim other assets of the individual as well. On a non-recourse loan, the lender can only seize the mortgaged property.
  • Annuities (see further discussion later) are economically equivalent to a private defined benefit plan in that they pay a continuing income stream. Their value should include some discount of future cash flows to reflect the potential the payer may default.
  • Cash-value life insurance is life insurance with a provision to borrow or take some present value portion of the future payout prior to death.
  • Business assets or private equity may represent a substantial portion of wealth for some self-employed individuals. This can lead to concentrated risk exposures in the investor’s wealth.
  • Collectables often involve substantial transaction costs and can have elements of personal consumption and utility as well as investment value.
  • Pensions can be a significant non-marketable financial asset for some. The pension could be from a private or government entity. The vested portion of the pension already belongs to the individual and can be valued as the discounted value of benefits to be received (PV). The discounting must also include a mortality projection if payments are contingent on the beneficiary being alive (which is typical). The discount rate will reflect the riskiness of the plan portfolio and sponsor as well as any other guarantees or insurance of payment. Future payments of the pension may be indexed for inflation. Typically government pensions will be less risky.

Expected defined benefit (DB) plan benefits for an individual have elements of both HC and FC. DB benefits are deferred labor income, which suggests treating them as HC, but they have already been earned and paid for with past labor to provide future cash flow.

Economic net worth extends net worth to include claims to future assets that can be used for consumption, such as human capital and the present value of pension benefits.

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