Human capital. Financial capital. They’re terms that sound like “business speak,” but when you boil them down, they’re just describing things that most people intuitively understand.
For starters, human capital is simply the skill, knowledge, and experience possessed by an individual (or population) viewed in terms of their value or cost to an organization or community. You have certain skills, character attributes, knowledge, and experience, and those are worth a certain amount to your employers and, for that matter, to your friends.
You can think of human capital in personal terms as the amount of money you’ve yet to earn over the course of the rest of your life. The younger you are, the higher your human capital is as you have more years in the workforce. The more skills you have, the higher your human capital. The more useful knowledge you have, the higher your human capital. You get the idea.
Note here that I’m not talking about human value, but human capital. Those are two very separate concepts. Human capital refers more to what others will pay you for the aspects of your life – your working years, your skills – that you can sell to them. Human value is completely different, as people have intrinsic worth regardless of what they’re able to sell.
On the other hand, financial capital is the sum of all of your assets minus your debts – your net worth, in other words. Add up the value of everything you own and all of your account balances and subtract all of your debts from that – that’s your total financial capital.
You’ll notice a few things about financial capital, too. In general, it’s lower when you’re younger. It tends to grow at a faster rate if you’re responsible with your money. Things that benefit your human capital tend to also benefit your financial capital over the very long run.
However, these two things also work against each other. They have an inverse relationship of sorts. Human capital slowly declines as you age and you become less reliable, as companies are less likely to invest in you and pay you well if you’re not going to be serving them and using your skills for them for very long. On the other hand, financial capital generally increases with age to a peak (usually right around retirement), then it begins to decline (as your human capital is very low and you’re not earning any additional income).
If you look at things from that perspective, you can see that the financial journey of a person’s life centers around the need to build up financial capital while human capital is strong so that the financial capital is there for you while human capital is weak. To put it in very simple terms, you work when you’re young and put aside money so that you don’t have to work when you’re old.
Every day that you work, in other words, you’re exchanging a little bit of your human capital – your time, your skills, and so on – for a little bit of financial capital – your paycheck. Naturally, you need to use that financial capital for life’s necessities, but at the same time, you also need to retain some of it for periods later in life when your human capital is tapped out.
The obvious, easy solution here is to just say, “SAVE FOR RETIREMENT!” That’s absolutely true – the whole purpose of saving for retirement is so that you can live off of your financial capital when your human capital is largely tapped out. Every single working adult should either be contributing to a 401(k) (or similar) plan or a Roth IRA or have a great reason for doing so – and “I need that money to pay my credit card bills” is not a great reason.
Still, that’s just the start of the implications of the balance between human capital and financial capital. Here are a few things you should be thinking about regarding that balance in your own life.
Don’t rely on your “future self” to bail you out of spending mistakes. As your life moves forward, your human capital is going to decline strictly due to age. Unless you have a huge increase in other dimensions of human capital – experience, skills, or other things – your human capital will be lower in a few years than it is now.
Thus, if you’re making financial mistakes now, like overspending and putting balances on credit cards, you’re actually relying on your future self – at a point in time where your human capital is lower than it is right now – to bail you out of this mess.
That’s a huge mistake. Your goal, right now, should be the opposite. You should be trying to make things easier for that future version of yourself by reducing the demands on human capital, not increasing them.
Invest when you’re young, even if you can’t invest much. This is something of a continuing thought from the above principle. The truth of the matter is that the earlier in life that you invest, the more time you have for your financial capital to grow up to a peak.
Why is that good? Well, let’s say it grows by 7% each year. The more years you give it to grow before you start drawing money away from it, the bigger it’s going to be. In fact, you can get away with contributing less each year to it if you start contributing earlier. If you’re saving for retirement at age 65, for example, and you save the same amount each year, the money you save from age 25 to 35 will end up building into more value than all of the savings from age 36 to 65. That’s the power of the long term.
If you’re not saving for retirement, start right now unless you have an incredibly good reason not to do so.
Ramp up your lifestyle very slowly, if at all. One thing many people do when they start enjoying the fruits of their human capital is that they ramp up their standard of living. They buy a fancy car and a beautiful house and all kinds of wonderful things to fill it with. They eat at nice restaurants, wear nice clothes, and have nice gadgets.
There’s a big problem with doing that, though. The money you’re spending on that stuff is being taken away from the vital task of building financial capital. Remember, your human capital is limited and every single day you drain away a little bit more of it. If you’re not putting aside financial capital, you’re going to be in a very bad place when it runs out.
So, instead of inflating your lifestyle every time your wages go up, hold back. Don’t immediately buy a new home and a new car to “fit” your new salary. Stick with what you have, raise your contributions to your financial capital, and make more subtle choices with what’s left over. Having a 20% smaller house, for example, can make all of the difference in the world here, since you’re not paying for the mortgage interest, the higher insurance, the higher property taxes, and so on.
Building skills, getting certifications, and so on is all about building your human capital, so the earlier you do it, the bigger the long term impact. Today is the day to start working toward building the skills and earning the degrees and certifications you might need to take the next step in your career path, whatever it might be. The sooner you do it, the bigger the boost you give to your lifelong human capital. The longer you wait, the smaller the boost.
When you’re in your twenties, don’t spend every evening partying and clubbing. Spend some of it training and preparing for what’s next. You won’t miss a few of the forgettable events, but you will enjoy the benefits of a huge increase in your human capital. It will help you throughout the rest of your life.
Your human capital is limited. What can you do to build it up? And, what can you do to build your financial capital for when that human capital runs out? If you don’t have answers to those questions, you’re setting yourself up for enormous financial disasters down the road.
Good luck.
The post Human Capital versus Financial Capital: What They Mean and How You Can Take Advantage of the Difference appeared first on The Simple Dollar.
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