Conceptually, the nature of one’s work and its compensation can introduce volatility. For instance, managing a hedge fund may impart an equity-like component to one’s human capital. Similarly, receiving company stocks or options can also add to this volatility.
The stability of your income shapes your investment strategy. If your labor income is unpredictable or tied to factors beyond your control (idiosyncratic and uninsurable risk), you should generally reduce risk in your financial portfolio to offset this uncertainty. For example:
If you work in a secure, high-demand field (e.g., healthcare or education), your income risk is low. This stability allows you to take on more financial risk, such as a higher allocation to stocks.
Conversely, if your income depends on market performance (e.g., a stockbroker or real estate agent), your human capital is more “equity-like”, meaning it fluctuates with economic conditions. In this case, reducing exposure to risky assets like stocks may help balance your overall risk.
When part of your compensation includes company stocks or options, the volatility of these assets helps determine the discount rate for calculating your human capital. Higher volatility typically suggests a higher discount rate, reflecting the increased risk associated with the future value of these equity grants. Furthermore, the proportion of these stocks or options relative to your total compensation influences this rate; a larger proportion suggests a greater dependency on the company’s performance, thereby increasing risk and the discount rate.
However, this relationship is nuanced. Risk-tolerant individuals often gravitate toward riskier careers and portfolios, which can skew the apparent effect of income risk on financial decisions. Still, the principle holds: higher labor income risk warrants a more conservative financial portfolio.
When income risk is independent of asset returns and cannot be traded away or diversified, consumers with standard preferences should optimally tilt their investment portfolio away from risky assets. As a response to this “background risk”, households with higher risks with labor income risk should be less likely to participate in the stock market, and should hold less risky assets.
Different approaches to human capital, wherever it is considered as a risk-free asset or risky asset, and starting conditions (e.g. student loans, family support, etc) will lead to different optimal asset allocations.
Your human capital behaves like a hybrid of bonds and stocks:
For most people, income is relatively stable and grows with inflation, resembling Treasury Inflation-protected Securities (TIPS). Early in your career, this steady cash flow dominates your wealth, making your human capital “bond-like”.
Promotions or career advancements can lead to sudden income jumps, akin to equity growth. On the flip side, job loss or economic downturns can cause income to plummet, introducing volatility.
As you age, your human capital diminishes because you have fewer working years left. Simultaneously, your financial capital grows through savings and investments. This shift naturally leads to a more conservative investment approach over time, focusing on wealth preservation rather than accumulation.
Understanding how human capital volatility correlates with different asset classes is vital for effective portfolio diversification. Several primary considerations include:
The correlation between your human capital and stock market returns depends on your profession. For instance, if your income is tied to market performance (e.g., finance), your human capital is positively correlated with stocks. For instance, consider a university professor and a stockbroker with equal human capital and financial capital values. Intuitively, one might assume the stockbroker should invest more heavily in stocks. However, given the stockbroker’s human capital is more sensitive to market fluctuations, a lesser allocation in stocks might be prudent to maintain a balanced risk across their total wealth. In such cases, reducing your stock allocation can help mitigate overall portfolio risk. Research supports this, showing that incorporating volatility risks into portfolio decisions can improve outcomes.53
Human capital often mirrors bonds, especially for those with stable jobs. If your income is predictable, you can afford to allocate more to riskier assets like stocks. However, the type of bonds in your portfolio matters. Government bonds, for example, are less volatile and may complement your human capital better than corporate bonds, which carry higher risk.
The relationship between human capital and real estate depends on factors like your location, industry, and job mobility. If you work in real estate or a related field, your income may already be tied to property market fluctuations. To avoid overexposure, you might consider diversifying away from real estate investments.