With any investment portfolio, diversification is critical to maximizing return. Diversification can merely be defined as “not putting all your eggs in one basket.” Here’s an example of why not diversifying is bad: when too-big-to-fail energy company Enron collapsed, so did its employees’ retirement plans. Why? According to The New York Times, Enron’s 401(k)’s asset value was approximately $2.1 billion before the collapse, with more than half of its assets invested in the company’s stock. Although employees had the option to choose other financial assets, satisfied with Enron’s financial performance, many invested heavily in the company’s stock. Therefore, when the company’s stock plummeted, employees’ retirement accounts were wiped out in little to no time.
A well-diversified investment portfolio should not only include financial assets but human capital as well. What exactly is human capital? Human capital is the present value of all potential earnings during an individual’s lifetime. So for instance, the compensation you expect to receive during your lifetime is considered your specific human capital.
More importantly, your human capital is, in fact, a traditional asset and should be taken into consideration when diversifying. Like other assets, human capital can be considered either safe or unsafe. A tenured professor at a university may be deemed to be “safe” human capital because he has a steady stream of income. Therefore, it may be more appropriate for that professor to invest in riskier assets, such as stocks. In contrast, a person whose salary fluctuates, such as a retail sales associate, may be considered to have “unsafe” human capital. It may be more appropriate for that individual to invest in less risky assets, such as bonds.
Also, if a person is working for a company and is investing heavily in the company’s stock, that person’s investment portfolio is poorly diversified. If the company has a bad financial year, that employee may be overly exposed to the company’s risks and may experience an economic mishap similar to those experienced by Enron’s employees.
Managing the Risks
Just as there are risks associated with stocks, bonds, and other investments, there are also risks related to your human capital. Human capital is exposed to both earnings and mortality risks. Some things an individual can do to reduce his earnings risk is to establish an emergency fund or create a credit line to withstand periods when there is a disruption of income.
Human capital is also exposed to mortality risk. Mortality risk is the chance an individual may die prematurely at a time when their dependents need their financial contributions the most. Maintaining life insurance is one way to address this concern as it helps protect against the risk of depleting human capital at the time of death.
So, before developing your investment portfolio, take time to understand your specific human capital. Understanding your particular human capital may allow you to build financial freedom for yourself and generations to come.