Chapter 14 – Human Capital Investment

The most important asset you have is yourself - your knowledge skills and abilities. choosing carefully how to build your skills can have dramatic effects on your financial future.

There are two primary forms of investment. The first is purchasing investment assets, such as stocks, bonds, and mutual funds. This is what comes to mind immediately for most people when they hear the word "investment". But can also invest in yourself. This kind of investment is called human capital investment.

We invest in human capital by increasing our knowledge, skills, and abilities. The primary method for investing in human capital is by going to school. However, this is not the only way to invest in human capital. Simply practicing any talent or skill will develop and increase your human capital.

We care about increasing human capital for two reasons. First, human capital provides direct utility. For example, developing the skill to play the guitar allows you to use that human capital to have fun and make you life better.

The second reason we try to increase our human capital is because it is the source of all other assets. We use our knowledge and abilities to earn money. We do this by getting a job and going to work. The more valuable your human capital is, the more money you can earn in the labor market. In other words, human capital can be transformed into money through labor.

Deciding which human capital (ie which skills and talents to develop) to develop is only the first step in human capital planning. You also need to develop a sense of how you will get the most out of those skills. You need to ask yourself questions such as: Which types of jobs will I take? How will those jobs further develop my skills and move me towards my ultimate life goals? By so doing, you can maximize both the amount of human capital you have, but also the amount of financial capital you has as well.

Phases of Human Capital Planning

The primary goal of human capital investment is to transform your human capital into financial capital. This occurs in three different phases of a person’s lifetime.

The development phase occurs when you are young, before you fully enter the workforce. During this phase, you need to determine your natural advantages. What are your natural talents and interests? It can take many years to discover your own abilities and interests. Don't get distressed. School can help you find topics and fields that interest you, the you would never have known about otherwise. This is one of the big advantages of taking a broad range of courses in college.

During this phase you will need to determine your life goals, and how your career path will help you reach those goals. You cannot make informed decisions about the training and education you will need if you do not know your goals.

Remember that goals can change throughout your life. That's okay! Our preferences change as we age and our circumstances change. What's most important is that you start building your knowledge and skills in a positive way. You can always switch gears or change directions later. The only wrong choice is to learn nothing at all!

During the production phase of the lifecycle, you spend your time and effort converting your human capital into financial capital by working in various jobs and positions. This is a critical part of increasing your skills. You will certainly learn more outside of school than you learned inside it. Carefully consider the employment opportunities you choose to take. Make sure they are in line with your career goals. Almost every job will teach you some skills. Choose jobs that teach you valuable skills that align with your goals. Carefully select jobs that not only fulfill your career goals, but help you to expand your knowledge and skills for future jobs.

The final phase is retirement. It's at this time that your human capital has been greatly reduced due to age. This phase requires you to develop a plan for how you will use the financial capital you have worked so hard to acquire to fund your life goals. Consider carefully where you will live and what you want to do with your time in retirement.

It can be even more difficult to make your retirement money last your entire life as it was to save up for retirement in the first place. It can be all too easy to accidentally spend your money before you have reached all of your goals. Plan your retirement funding carefully, and don’t be afraid to ask a reputable financial professional for some help.

Return on Education

Every person who has ever gone to school knows that investing in human capital is a difficult process. Is this human capital investment really worth making? To answer that question, we must determine what the return on the investment (or ROI) for your education.

How is the ROI calculated? Let’s do an example for a 22-year-old student and a 45-year-old student. To find ROI, we need to know the costs and benefits of the investment. In our example, the cost of the investment consists of two components. The first is tuition, books, and fees. Let’s suppose that you do some research on your college of choice and decide that these costs total $100,000 over the course of four years. The second component we need is the opportunity cost. This is the value of the wages that the student could have earned if they were working full time instead of being in school. At $20,000 per year for 4 years, this amounts to $80,000. Adding these two costs together gives a total cost of the education as $180,000.

The average benefit of a college education is an additional $20,000 of income each year for the duration of the student’s career (45 years in the case of the 22-year-old). To get the ROI, we simply plug these costs and benefits into our financial calculator and solve for the interest rate. N=45, PV=-180,000, PMT=20,000. This gives us an ROI for the 22-year-old student of 11%. That is a good return on an investment.

Now let’s consider the 45-year-old student. His cost of tuition, fees, and books is the same $100,000 that the 22-year-old student had to pay. However, since he is older and has higher earning potential in the workforce, his lost wages is higher. If he could have earned $37,000 per year for 4 years, giving a total amount of lost wages of $148,000. Adding this cost to the tuition cost gives a total cost of the education of $248,000. The benefit of the investment is the same $20,000 per year in income. Since the student is already 45 years old, he does not have as long of a work horizon over which to claim this benefit. Entering N=25, PV=-248,000, and PMT=20,000 into the financial calculator and solving for the interest rate gives an ROI for the 45-year-old student of 6.32%. This is still not a bad return, but it is much lower than the return for the younger student.

This leads us to an important point. The sooner you invest in your human capital the greater the potential rewards! What this means is that you should try to study hard, complete your education, and generally improve your knowledge and skills as early as possible in life, in order to get the most value from your studies.

This is an excellent time to watch Lecture 10 from the course pack.

Definitions:

Investing: using resources you have in the present for anticipated payoff in the future

Human capital planning: a full plan for how you will acquire your human capital and also for how you will use it to generate financial capital

Human capital investment: the transformation of human capital into financial capital

Pre-production stage: occurs when you are young, before you fully enter the workforce

Production stage: occurs when you spend your time and effort converting your human capital into financial capital by working in the labor force

Post- production (retirement): occurs when you develop a plan for how you will use the financial capital you have worked so hard to acquire to fund the life goals you have set for yourself

Return on Investment (ROI): a common measure of the relative value investment