Human Capital: Are You a Stock or a Bond?

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Over at Bogleheads there was an interesting thread which explored how finance professor Moshe Milevsky has been pushing the concept of human capital as an additional variable to the traditional ideas of net worth, portfolio construction, and asset allocation. These are explored in this this trade magazine article for financial advisors, this draft academic paper, and also in his book Are You a Stock or a Bond?.

Human Capital
There are some differing definitions, but below is a brief explanation (taken from the magazine article above) of what is meant by human capital here:

Human capital is a measure of the present value of your client’s future wages, income and salary (net of any future income taxes and expenses). For example, if she is a doctor, lawyer, engineer or even a professor, she has probably invested an enormous amount of time, effort and money to finance her education. That investment will hopefully pay off over many future years of productive labour income in the form of job dividends over the next 10, 20 or even 30 years. Sure, clients can’t really touch, feel or see human capital, but like an oil reserve deep under the sands of Alberta, it will eventually be extracted and so it’s definitely worth something now.

Milevsky likes to talk about people as businesses and thus includes human capital on the balance sheet of “Me, Inc.”:

When you’re young, your human capital may very well dwarf your 401k balance. With this in mind, it may make you feel better about any short-term losses.

Your human capital can be viewed as a hedge against the losses in your financial capital. So, as a 50-, 40-, or especially 30-year old, you should be willing to take more chances with your total portfolio, perhaps even borrow to invest or leverage into the stock market, because you have the ability to mine more human capital if needed.

Am I a Stock or a Bond?
One characteristic of your human capital to think about is if it tends to act like a stock or a bond. As a tenured university professor, Milevsky offers himself up as a good example of a bond that offers a reliable and steady coupon (paycheck). However, an small business owner, investment banker, or even a car salesman would have an income that is much more correlated with current economic conditions – much like a stock would.

A common piece of advice that relates to this is when people are told not to hold too much of their employer’s company’s stock (often in 401k plans). Since your salary is already tied to that company, it would be wise to add some diversification so that all your eggs aren’t in one basket.

Along the same diversification argument, if you are a “bond” then you may be able to take more equity risk in your retirement portfolio. On the other hand, if you are a “stock” then you may want to reduce your exposure to stock market swings. “Your invested assets should zig when your salary zags… tilt your financial portfolio away from your human capital.”

Unfortunately, rarely are things so simple. Human capital is at best a guess of the future, and you could be really far off. And just because your income isn’t tied to the stock market, doesn’t necessarily mean you can stomach the swings of a highly risky portfolio. If you’re the type to panic and sell at the bottom, perhaps increasing stocks would only hurt your long-term investment returns.

I like to imagine a good financial couple as one that pairs up a stock and bond. Perhaps one person holds a steady government job with a pension and healthcare benefits into retirement, while the other is an entrepreneur that takes some risks and tries to strike it big.

Also, what if I don’t want take advantage of all my human capital? Sure I could work for another 35 years and consider a big chunk of human capital in my net worth, but I’d really rather not. 🙂

What do you think of this concept?

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  1. The model makes sense, but I disagree with the investing part. I am a “bond” with a steady predictable income. I agree I should be investing in stocks. However I think the reason is because I’m young. You should invest money you will need soon into something safe and dependable. You should invest money you will need many years out in something more risky but more profitable. That’s what should base your decisions. True, a person in a risky job always deals with the threat that they may need their money sooner, but that’s no excuse for a 25 year old investing overly cautiously.

  2. simplesimon says

    I have to disagree with Dave about being young (or any age) as a reason to invest a particular way. Who is to say what is aggressive and what is overly cautious? People should invest with what makes them comfortable. People should invest in a portfolio that matches their risk tolerance.

    That said, I have mixed feelings about this particular thinking of human capital. You’ve heard stories about tenured professors having to delay retirement because their portfolios took a beating during the downturn. Sure they have the means to work longer and save more to make up those losses, but do they really want to? Like Jonathan, I’d rather not.

  3. Simplesimon,
    Your professor reference proves my point. Those progressors are delaying retirement because they were invested too aggressively for their age. A younger professor with 10 years left to recoop his value wouldn’t be hurt so much. Or maybe a more accurate way of looking at it is that they had predicted their retirement date based on the erroneous notion that the market goes up up up and it couldn’t possibly go down.
    Yes, people should invest in a portfolio that matches their risk tolerance. But there are more than one types of risks. As a frugal 30 year old teacher I can invest fairly aggressively and be pretty comfortable I’ll be able to retire nicely at 60 or 65 or maybe 55 if I get lucky. Or I can invest conservatively and know for sure I’ll be retiring at 70+. There are different types of risk, but since time itself minimizes risk, then it’s foolish to ignore age as a variable, and the younger you are, the more foolish it is to invest conservatively.

  4. Nothing gets the week off to a better start than reducing the value of a human being down to dollars and cents.

    I feel all warm and fuzzy.

  5. it’s an interesting way to look youself and your career path in terms of your portfolio planning. I think using this model to try to allocate this and that is sort of negated by your risk tolerance and your specific savings goals.

  6. Yeah ! I am diversified.

    As a independent software consultant , I am stock (albeit a fairly predictable one , an utilty or something – no GOOG here ) , this is reflected in my money management with a significant emergency fund.

    But as my skills are in pretty good demand for full time jobs … if thinks go south I am pretty confident I would be able to get a Job … so that’s my bond side

    I like it !

  7. LeanLifeCoach says

    Warren Buffett said “The best investment you can make is in yourself… the best asset you own is yourself.”

    The greatest potential most people have is their ability to generate an income. Most of us must face it; we are not likely to become a Gates or Buffett so we must make the most efficient use of the revenues that we do create.

    However, in the business of Me Inc., you also need to add a few more lines to the liability side… like laziness, and ignorance. These two characteristics destroy more potential than anything else.

  8. It’s not hard to view this concept as a feeble effort to prop up capitalism’s intellectual underpinnings. It’s a philosophical bailout.

    Capitalism sucks, and this idea does not work in its defense.

    I love your blog, Jonathan, not least because because I find the underlying tension between your altruistic yearnings and your axiomatic capitalism fascinating.

  9. Alex Coward says

    Bankers are way ahead of you. This is the premise of your mortgage (or any loan for that matter) in a fractional reserve system.

  10. OK, first off, the balance sheet is un-balanced.

    If you have “human capital” on the left you have to things like “personal health”, “continued education” & “personal time” on the right.

    This is not commentary on his book, just on the diagram above. The following quote from an Amazon reviewer may be telling of the book: “Dr Milevsky does an excellent job discussing the dual uncertainties of retirement planning: uncertainty of longevity, and uncertainty of portfolio duration.”

    If that’s the focus of the “human capital” idea, then I think that Milevsky is at least barking up the right tree. Most retirement plans are poorly focused on the value of human capital. Then again, most retirement plans seem to think that we can all spend the last 25% of our life “doing nothing” while spending the first 25% of our life being educated. (which seems like pretty bad math)

    @Jonathan: “Human capital is at best a guess of the future, and you could be really far off.”

    Yeah, we haven’t figured out how to get rid of that pesky “future guessing” problem.

    Look, an average person’s ability to guess at both their future income prospects from their job is magnitudes better than their ability to predict something like the stock market. If anything this re-enforces the value of managing your “human portfolio”.

    “Also, what if I don’t want take advantage of all my human capital?…”
    Well then we’ll just throw you in the casket right now. Your magic plans of saving up a giant wad of cash and then spending the rest of your days “retired” are just foolish. At best you’ll do something other than what you’re doing today. But you’re stuck managing your human portfolio until you die.

  11. I’m not sure I like mingling intangible assets (human capital) with real assets, debts, liabilities. You have to offset your potential with the potential something could wipe out your personal worth, such as major illness.

    I do, however, think it is an excellent idea to look at yourself and see how you can improve your financial performance. Is a $2000 training course going to allow you a good return on your investment such as an increase in salary or your ability to spot investment opportunities? Remember, the goal is to not rely on W-2 income, just as a means to an end. Hopefully, we’ll all be behind the wheel of some big company, making investments, and living the rich life 😉

    Also, I have to point out that Car & Vehicles aren’t really assets. They could be technically labeled as depreciating assets, but I like the definition of an asset as something that makes you money. In which case, you yourself can be an asset… most of the time.

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