Human capital in asset allocation plans

Human capital in asset allocation plans

Adaquant Asset Allocation Suite also supports human capital in the asset allocation plans. Human capital is defined as the total value of your future savings.  When human capital is considered as an asset class, it basically means that you are the asset. Your skills, knowledge and experience enable you to earn money. If you earn salary or other income that exceeds your costs, then your human capital has a positive value.

If you are a young person, for example just graduated from the university and starting your career, your human capital has the highest value. You have a long time until retirement to gather savings. On the other you might not yet have invested much into financial asset classes. Therefore, for young and middle-aged people, human capital is often the most valuable asset that they possess. When years pass by, you gather savings and invest them into financial assets. But at the same time the value of your human capital decreases because you have fewer years left to generate savings.

Human capital of two different persons may have different types of characteristics. The human capital can be very stable, let’s say if you are a professor in a university. It is less likely that you would lose your job or that the earnings would decrease suddenly. If you are an entrepreneur, you may be able to generate a lot of earnings but they might be very volatile. Some years you earn well, some years less and there is always some probability that something goes wrong with your business. Yet another type of human capital is possessed by for example equity portfolio manager, where the earnings are not only volatile but also heavily correlated with the stock market returns.

So how should human capital affect your asset allocation decisions? Although the human capital can be included to the asset allocation plan as a separate asset class, in my experience only in very extreme cases it has a significant impact on the results. Therefore I prefer to do asset allocation plans without human capital and only in rare cases make some manual adjustments.

The questionnaire configured to the Suite includes questions on the investment horizon and riskiness of your human capital. Therefore the proposed risk targets are already impacted by your human capital characteristics. The only case that is not tackled by the questionnaire is when your human capital is correlated with some of the financial asset classes. There I would just use common sense to limit investments into the correlated asset class. For example, if you are equity portfolio manager, it makes sense to invest a bit less to equities compared to the target weight of your asset allocation plan. However significant changes need to be rarely done unless the correlation is really high (>0.7).

However, if you want to experiment with the human capital asset class in the Suite, here are some practical tips:

  1. You need to first define the value of your human capital. Go to menu Tools / Asset Classes. Select one of the pre-configured human capital asset classes and press “Savings Calculator” button. Set as input your “Annual savings” (annual income minus annual costs). If you are already accumulating these savings, set “Start year of savings” to 0. “Years of savings” is how many years you are accumulating the savings. Let’s say you have 30 years to retirement and after that you will not gather any savings – you should set this field to 30. Discount rate is used to discount your future savings. This basically means that you discount the value of future savings because they are much less certain than the current savings. The further the savings are, the more they are discounted. If your human capital is stable, then you can use lower discount rate (for example close to fixed-income long-term returns) and if volatile, then higher discount rate (for example close to equities long-term returns). The Suite has pre-configured values for the discount rates. Click “Calculate” and you get the value of your savings in “Current value of savings”, let’s say it is 200’000.
  2. Now close the asset class window and open from the menu Tools / Portfolios. If not already done, create a new portfolio for you. Find in the list of asset classes your human capital asset class and click the pen symbol. Window opens for you to edit the investments. Set “Amount” to 200’000 and save. You should add also the other investments to your portfolio. As a result, the human capital will be certain percentage of your investment portfolio, let’s say it is 60%. Close the portfolio window.
  3. Create yourself a new simulation if you have not already done so. Select as “Portfolio” the portfolio you did in step 2. Then click “Advanced Settings” button. Check the box “Include Human Capital” and close the advanced settings window. In the main window you see now that all the human capital asset classes are included to the plan, and they all have “Lock to Current Weight” box checked. You also see the weight 60% in the human capital asset class that you added to your portfolio.
  4. Run the simulation

As you can see, the human capital weight is always locked in the simulations. It is because human capital asset class cannot be bought or sold. The simulations are nevertheless now done so that the weight of human asset class is constant in all simulated portfolios. After the simulations have been done, the human asset class is removed from the portfolios and all weights of the financial asset classes are scaled so that they sum to 1. These portfolios are then compared to the asset allocation plan targets to pick up the best portfolio that satisfies all the targets. The resulting asset allocation plan report also does not contain human asset class, but only the financial asset classes so that their weight sums to 1.

By |2018-08-12T16:07:56+00:00February 16th, 2018|