money health weekly


What Does Your Paycheck Have To Do With Your Investments?

Let me tell you a story. I have a friend who I'll call Gus. Gus is a tenured college professor. Gus gets paid twice a month, no matter what is happening in the outside world. Gus has very little risk of getting fired, so his paychecks are very predictable. I have another friend who I'll call Jesse. Jesse is a salesman who sells research to investment companies. His paycheck depends on his ability to sell information to firms who invest in the markets. When markets are up, things are good for him. If markets crash, these companies don't have the revenue to spend on research and his income goes down. Even worse, his job could be at risk if his firm loses enough revenue. This would happen at the exact same time his investments are down.

If the market crashes, Gus is going to do just fine as long as he doesn't have to take any withdrawals from his investment accounts. He shouldn't have to, remember, because he has a very steady paycheck coming his way and that money will not only cover his bills, but allow him to save and invest more at the market's lower prices.

Jesse, on the other hand, could lose his job if the market crashes. This would be devastating because at the same time he lost his income stream he would also have a lower investment account balance. If he would have to sell investments to cover his bills he would be forced to sell his investments and lock in those losses.

Gus and Jesse have vastly different characteristics of their human capital.

What Is Human Capital?

Human capital is your ability to earn money. You trade your time, skills, ability, creativity, talent, or knowledge in exchange for income. Technically speaking, this is the value in today's dollars of all future paychecks. If you are young and just out of college your human capital is very large - the largest it will be in your lifetime. If you are nearing retirement, you have run out of years available to earn money, so your human capital is very small (of course, the lack of time available to earn money is offset a little bit by the fact that you are likely making a higher salary).

What Is Financial Capital?

Financial capital is what most people think about when they hear about financial wealth. This is the amount you have saved and invested. It could be in savings accounts, CDs, stocks, bonds, properties, or any other income-generating asset you can think of. When we are first starting out, we have very little, if anything, saved but we have our whole lifetime of earnings ahead of us. Said another way, we have a lot of human capital but very little financial capital. The flip side is that at retirement we have a lot of financial capital saved, but we have very little or no human capital left.

Interaction Between Human and Financial Capital

Strictly speaking, to live the richest life possible our goal should be to convert our human capital into financial capital. I promise you there are heartbreaking stories of people who have high incomes who spend it all, failing to convert their income into financial capital by saving (although I'm sure there are many who have little sympathy for high-income earners!). The flip side is that we've all heard of situations where people with middle to low incomes become millionaires because they were very skilled at converting their (little) human capital into financial capital - they were savers! Conver