It's ugly out there. Millions of people have lost a major part of their financial assets. Millions more have seen the value of their home decline.
So let's talk about what's left: human capital.
Human capital is the forgotten part of personal finance. One reason is that the financial services industry is so entirely focused on the products it sells -- financial assets. Another reason is that human capital is difficult to talk about.
But human capital is important because it is the primary asset we all have.
Skeptics should consider a simple example -- how much you would need in financial assets to replace your paycheck. A worker who earned $50,000 a year, for instance, and who may have 20 more years to work would need to have about $1 million in financial assets to replace his ability to work, his human capital. A more precise estimate of value would have to deal with inflation, wage gains and whether a particular set of skills is likely to be in greater or lesser demand.
Here's a practical example of human capital. For years I have recommended that younger workers avoid debt, defer homeownership and have a stash of cash rather than stocks. Why? Because they are the most important asset they have. A young worker's ability to negotiate a better wage or salary depends entirely on her freedom from debt and the ability to pursue opportunity. Their financial capital -- their savings -- is best used as a tool to leverage their human capital.
The task all human beings face is to employ their human capital -- their ability to work -- and convert it to financial assets. That's how we can sustain ourselves when we can no longer work, or choose not to work.
You've heard little about human capital before because the subject only recently emerged from academia. But the idea is emerging rapidly today. Here are two examples.
In "Spend 'til the End" (Simon & Schuster, $26), economist Laurence J. Kotlikoff and I show how our human resources should affect our investing. We take issue, for instance, with the oversimplification of today's "target date" mutual funds. Age isn't the only factor in how we invest. Another factor is the security of our employment and how our compensation is figured.
That idea is developed very nicely in "Are You a Stock or a Bond?" (FT Press, $26) by financial economist Moshe A. Milevsky. He points out that a tenured college professor might consider himself to be a "bond" due to the security of his income. A district sales manager, however, might be considered a speculative stock.
Both need to invest their savings accordingly. Unlike an earlier book that he co-authored with Roger A. Ibbotson, Peng Chen and Kevin X. Zhu ("Lifetime Financial Advice: Human Capital, Asset Allocation and Insurance," Research Foundation of the CFA Institute), "Are You a Stock or a Bond?" is an easy read. It's also only 200 pages.
If you want to understand the basic issues you face in creating a sustainable standard of living through retirement, Milevsky's book is a must-read.
Trust me, we're all going to hear a lot more about human capital, and soon. One indication is the 2008/2009 catalog of services from Morningstar. A research article in the catalog discusses human capital and takes issue with the target date mutual funds.
"Today's investors face a choice of target date funds that range widely in their equity allocations -- and have no way to gauge which is most appropriate for their needs," the article observes. Funds maturing in 2010, for instance, have equity allocations that range from 79 percent all the way down to 28 percent.
They can't all be right.
In fact, your retirement-year allocation depends on your age at retirement, whether you have a defined-benefit pension and a host of other factors. A worker with large Social Security benefits, a hefty corporate pension and a mortgage-free house, for instance, can commit much more to equities than a worker with mortgage payments, no pension and smaller Social Security benefits.
Those differences change how we invest -- now and in the future.