Don’t invest in the sector you work for

You often diversify your investment portfolio. But do you consider your earnings potential or human capital while creating your “diversified” investment portfolio?

In this article, we discuss why you should integrate your human capital with your investment portfolio.

But given the practical issues in quantitatively integrating the two, we offer two suggestions: moderating your human capital risk and qualitatively integrating your human capital and investment assets.

Integrating assets You possess two assets — human capital and investment assets. Your human capital is the present value of your future active earnings. It will depend on where you are in your working lifecycle.

Your human capital is large at the beginning of your career and small when you are close to retirement.

The point is this: you will gradually convert your human capital into investment assets during your career. How? You save a proportion of your monthly income. Your savings, if invested judiciously, will grow into sizable capital which you can use during your retired years.

Logically then, diversification is very important when you gradually convert your human capital into investment assets. Why?

Suppose you are employed in the technology sector and you invest heavily in technology stocks and mutual funds. What if the technology sector suffers a steep downturn? Not only is your earnings at risk but so is your investment portfolio.

Ideally, you should create your investment portfolio such that the loss of your income does not affect the value of your investments. Of course, that is easier said than done in a highly globalised economy.

Besides, we live in a world where employment is typically not guaranteed. It, therefore, becomes difficult to quantify and effectively integrate your human capital with your investment decisions. As an alternative, you can moderate your human capital risk and qualitatively integrate your human capital with your investment portfolio. Here’s how.

Moderating risk You can moderate human capital risk in three ways. First, you can save more, especially if you have volatile earnings.

Your earnings will be volatile if your income is primarily based on performance incentives or you work in a highly cyclical industry. Your savings rate should then fall between 30 and 40 per cent.

Importantly, you should refrain from taking a home loan. This essentially converts your human capital into an investment asset. The problem is that you will be converting your human capital into a lumpy, illiquid and, hence, risky investment asset.

But what if you cannot save 40 per cent of your income? Our second suggestion is that you should consider enhancing your skill through continual professional education.

Higher education provides you opportunities to increase your current income and explore additional sources of income. You can, for instance, write a book during your leisure time, which can earn royalty income.

Increasing your income can help you accelerate the conversion of your human capital into investment assets.

The third way by which you can moderate your human capital risk is to buy appropriate life insurance contracts.

Life insurance hedges your mortality risk — specifically the risk that you will pass away before you convert your human capital into investment assets.

Remember, your human capital is highest when you start your career. And that is when insuring your life could be more valuable to family members dependent on you.

It is important that you qualitatively consider the characteristics of human capital while making your investment decisions. If possible, do not invest in stocks and bonds of companies in the sector in which you are employed.

Besides, if you have volatile earnings, invest more in stable cash flow assets such as bonds, specifically bank fixed deposits, to balance the overall risk. But first moderate human capital risk.

(The writer is the founder of Navera Consulting. Send your queries to >portfolioideas@thehindu.co.in )

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