Every Money Decision Begins & Ends With Your Job
Here's a simple framework to help you make rational money decisions
Most people don’t have a clue how wealthy they really are.
Your net worth or total wealth = assets - liabilities.
So, most people add up the value of all their financial assets like stocks, cash, bonds, and real estate and subtract the total value of all their debts to determine how much wealth they have.
Assets minus liabilities might be how a financial advisor defines wealth, but if you ask an economist, they will give you a very different answer. As I review in chapter 2 of my next book (working title: “The Rational Investor”), the financial advisor’s definition of wealth excludes your largest asset; your human capital.
In today’s post, I review why your human capital (how you make money) is the most important factor in nearly every money decision from how to invest to how much insurance you need.
Total Wealth = Financial wealth + Human Capital
If you’re 25 and plan on working until 65, you have as many as 1,040 paychecks left to collect in your life.
Those 1,040 paychecks (or how many you have left to collect) can be assigned a present value.
If you have 40+ years to collect 1,000+ paychecks, the present value of those paychecks is likely worth a few million dollars.
For young people and those without a lot of financial assets, their human capital is by far the biggest asset they own. But ask yourself, how often do you factor in your human capital, aka “how you make money,” when making big financial decisions?
I hope the answer is “all the time,” but for most people, it would be “rarely, if ever.”
Two Questions That Help Answer Most Money Decisions
How secure is your job?
How many working years do you have left?
Answering these two questions can help you determine how risky your human capital is and how much of it you have left.
I’ll use two examples that are polar opposites to illustrate how these factors impact decisions around investing, emergency funds, and insurance.
Example 1: 37-year-old professor with tenure and workplace pension
Let’s call this person Claire.
Claire has a high degree of job security and likely 30+ years of paychecks to collect.
The fact that Claire has 30+ years of paychecks to collect means the present value of her human capital is large.
The high level of job security means her human capital is not very risky.
Access to a Defined Benefit pension means she will have a risk-free income stream in retirement.
We would look at Claire and say her human capital looks like a bond. It’s low risk and provides a stable and predictable coupon payment every two weeks.
Example 2: 64-year-old business owner
Let’s call this person Bryan.
As a business owner, Bryan’s income is never guaranteed. If the business does not perform, he does not get paid, and he likely only has a few years left before retirement.
Since Bryan is very close to retirement, the present value of his human capital is relatively small. Even if he makes a lot of money, he only has a few more years to collect the income.
Given the nature of owning a business, Bryan’s income is very volatile; some years are better than others.
Bryan has to self-fund his retirement.
We would look at Bryan’s human capital and say it looks like a stock. It’s risky but has large upside potential.
Knowing nothing else about Claire or Bryan except the makeup of their human capital, here’s how they would differ on issues like investing, emergency funds, and insurance.
How human capital impacts investing decisions
If Claire’s human capital is large and bond-like, and her pension will provide her with bond-like income in retirement, then she needs to invest her financial capital heavily weighted towards stocks because the majority of her wealth is already invested in bonds.
On the other hand, Bryan’s human capital is small and volatile like a stock. Bryan has no pension to provide him risk-free income in retirement. Bryan would allocate more of his financial capital to bonds to counterweight his risky human capital.
All else being equal…
The more years you have until retirement means your human capital is larger which means you would allocate more of your financial capital to stocks.
The more secure your job is, the more your human capital resembles a bond which means you would allocate more of your financial capital to stocks.
Human capital and the size of your emergency fund
As a tenured professor, it’s unlikely that Claire would lose her job.
That might suggest that she needs a smaller emergency fund. But also consider that it could take over a year to land a replacement job in a similar role at another University.
Here’s a rational way to determine how much you need in an emergency fund.
Track your expenses and find out how much money you spend every month.
Research how long it would take you to land a new job that you are happy with if you were to get fired.
Multiply your average monthly spending in step 1 by the number of months in step 2.
If you spend $5,000 per month and it would take you around 6 months to land a new job, you’d want to have $30,000 set aside in an emergency fund.
Human capital and life insurance needs
Term life insurance is the perfect hedge against dying and forever losing your human capital.
Every year you hold a policy, one of two outcomes will take place:
You don’t die, and the policy pays nothing, but you keep earning.
You die, and the policy pays out, but your family loses your human capital forever.
But how does the size and riskiness of your human capital impact how much life insurance you might need? This was one of the many questions examined in a 2005 paper titled “Human Capital, Asset Allocation, and Life Insurance” published in the Financial Analyst’s Journal.
Here’s a summary of their findings.
The larger your remaining human capital, the more life insurance you need.
In our example, Clarie, a 37-year-old, would likely need more life insurance than Bryan, who is 64 years old.
The riskier your human capital, the less life insurance you would need.
This might seem counterintuitive so let’s return to our example of Claire (the tenured professor) and Bryan (the business owner).
Since Claire has such a large degree of job security, the likelihood of her getting fired before retirement is low. That means she is more likely to collect 100% of her human capital— Unless she dies prematurely—which is where the need for a greater amount of life insurance comes in.
Look at this from Bryan’s perspective. Most businesses are one lousy year from bankruptcy. That means he is much less likely to actually collect all of his remaining human capital. Since life insurance is a hedge for human capital, he needs less life insurance.
(Note: in the real world there are other practical reasons to buy life insurance beyond hedging human capital. This discussion falls under the “all else being equal” category that economists are so fond of).
A quick caveat and some homework
Of course, the size and riskiness of your human capital is not the only factor to consider when making money decisions, but once you realize your human capital is your largest asset, you can’t ignore it when planning your finances.
If you have not considered how your human capital fits into your finances, here are a few questions to get you started.
How much money do you make relative to your cost of living?
How secure is your income?
Do other people depend on your income?
Do you like what you do?
If you lost your job, how long would it take to find comparable work?
Is your workload sustainable?
Do you have access to insurance and retirement plans?
Do you have alternative sources of income?
Here Are the Two Exact Reasons the Wealthy Are Happier than the Rest Of us
My Medium article with the most views in the past week is titled “Here Are the Two Exact Reasons the Wealthy Are Happier than the Rest Of us.” Here’s a link to read it and bypass the Medium paywall. Please read the story, and if you liked it, leave 50 claps, so the Medium algorithm will help other people find my writing and grow this community.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.
Great explanation on the concept of human capital Ben. Breaking it down into remaining cheques is an interesting and novel way of
looking at your total wealth.