Personal Finance

You’re Worth Your Weight in Human Capital – Part 1

by Jeffrey Ryall CFA, CFP® - Associate Portfolio Manager at Cardinal Capital Management, Inc.

Transforming your biggest financial asset

As a young professional, you have probably spent countless hours and thousands of dollars completing a post-secondary education program and entering the workforce. This is only the starting point for developing your human capital – or the economic value of your skills and abilities.

What makes human capital unique, how is it valued, and how do we transform it from our biggest financial asset?

What is human capital?

In its simplest form, human capital is defined as the life-time value of an individual’s acquired skills, knowledge, and experience that can be converted in the marketplace into income (a financial asset).

Early in your career, human capital is usually your largest and most important asset. Human capital will increase in value as your skills, knowledge, and experience are further developed, but will eventually decline as one progresses through their career and wages have been earned. Ultimately, human capital is fully used up by the point of retirement or our death.

Not all human capital is created equally

There are several factors that may influence the value of your human capital:

  • Societal norms and values tend to place different values on occupations in the marketplace.
  • Labour market conditions are influenced by supply and demand for specific skills and knowledge.
  • Specialization and continued investment or maintenance in knowledge and skills tend to be rewarded.
  • Technology can cause temporary or permanent fluctuations in wage values.
  • Riskiness of occupation can demand premiums, such as hazard pay.   

Since the start of the Coronavirus pandemic, you have likely heard or read about how these changing factors have impacted individuals. Travel restrictions have caused an oversupply of workers in the hospitality and tourism industries, while contractors and tradespeople have been in high demand. Professionals have also been impacted; dental practices were forced to close for weeks and physicians who perform elective, non-urgent surgeries have seen their operating hours scrubbed.

Estimate the value of your human capital

Real life tends to be more complicated and uncertain than theories explained with fixed assumptions. An individual’s wages may grow faster or slower, the length of employment may be longer or shorter, and unexpected illnesses may reduce or impair human capital altogether. Nonetheless, one of the most common applications of calculating an estimate for human capital happens during the risk management process (when purchasing life insurance).

At a minimum, one needs to identify the following:

  • Current annual income,
  • Income growth rate, and
  • Length of working years

For example, a 35-year-old physician with an annual income of $300,000, who plans to work for 30 years, could have human capital valued today at ~$5,000,000.  

Transform your human capital into financial capital

Once human capital is depleted, without any other financial assets to rely on, an individual would have nothing to fund their lifestyle. Given this reality, it is imperative for individuals and their families to decide how best to transform their wages into other forms of financial capital that can be used in the future. Deciding when to spend, save, borrow against, or purchase protection, throughout your lifetime, are important decisions which will allow you to harness the full potential of your human capital.

Traditionally, individuals have used the concept of net worth to measure their ability over time to increase their financial assets and reduce their liabilities (debts).

Net Worth = Assets – Liabilities

One of the most common examples of this process in action is a family purchasing a house with borrowed funds from a bank (mortgage) and making monthly mortgage payments until the balance (with interest) has been fully repaid. Over time, the value of the house (an asset) will likely appreciate, while the mortgage (liability) decreases, as mortgage payments are made, resulting in an increased net worth.

In recent years, economists have advanced this concept of net worth to recognize the significant value human capital (a major asset) can have for individuals early in their career. However, there are many obstacles that can impede one from transforming human capital into other financial assets. Wages can be fully spent if savings are not set aside for your future. Illnesses can reduce or impair human capital before it has been transformed to another financial asset.

In Part II of this article, we will apply these concepts so you can harness the full potential of your human capital.

“Success is not a random act. It arises out of a predictable and powerful set of circumstances and opportunities”

Malcolm Gladwell, Outliers: The Story of Success

The decisions you make now are cumulative and can influence your finances throughout your working career and into retirement. Everyone has a different ability and willingness to accept risk, lifestyle expectations, and savings capacity. Speak to a financial planner and build a personalized financial plan that works for you and your human capital.

Notice to Readers: Unless otherwise noted herein, the sources of all performance data is Bloomberg and Cardinal research. This article has been prepared for general informational purposes only, without reference to the investment objectives, financial profile, or risk tolerance of any specific person or entity who may receive it. Investors should seek professional financial advice regarding the appropriateness of investing in any investment strategy or security and no financial decisions should be made on the basis of the information provided in this newsletter.

About Jeffrey Ryall

Jeffrey Ryall, CFA, CFP®, is an Associate Portfolio Manager at Cardinal Capital Management, Inc. Jeffrey specializes in developing personalized financial plans and customized investment portfolios for professionals and incorporated business owners, with complex financial needs. If you have a financial planning question, connect with Jeffrey at [email protected] or through LinkedIn.

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