To diversify is human. Small wonder that many prefer to invest in diversified equity funds and keep fixed deposits across multiple banks. Previously in this column, we discussed how you can create a diversified portfolio by diversifying the source of returns — income returns and capital appreciation. In this article, we discuss why you should diversify with a view to reducing risk associated with your human capital.
Human capital refers to the present value of your future earnings (active income). It is difficult to determine your human capital, given the uncertainty relating to your earnings growth and the number of years you are likely to earn.
But it is important that you diversify the source of your family’s human capital, if possible. By this, we mean that it is optimal that you and your spouse work in different companies. That way, the risk of losing active income because of lay-offs is less than if both of you work in the same company.
The second aspect of diversification is between human capital and investment capital — two assets that every working executive has. Your investment capital is the accumulated wealth that comes from investing your savings. Your savings is a function of your active income.
It is, therefore, important that you do not have a significant proportion of your investments tied to the same source as your human capital.
For instance, having significant exposure to your employer stock. It is highly likely that a large-scale lay-off by a company coincides with its stock underperforming in the market.
At the extreme, one could argue that it is best to avoid exposure to stocks in the sector that you work so that your human capital has lower linkages to your investment capital. While practically difficult to do so, it is best that you consider investing in a large-cap or a broad-cap equity fund.
If you and your spouse work for the same company, you can consider two ways to moderate human capital risk. One, maintain a larger amount in your contingency reserve. For spouses aged 35 and above, it is optimal to have six times the average monthly expenses (including any monthly loan repayment) as contingency reserve. If you and spouse work in the same company, it may be optimal to increase this reserve by 30-50%. And two, you could strive to live on one-and-half income — your post-tax income after savings and half of your spouse’s post-tax income.
(The author offers training programmes for individuals to manage their personal investments)
