Valuing Human Capital and Integrating It into Portfolio Optimization

What is human capital and why does it matter?

In personal finance, human capital is the present value of all future labour income that an individual will earn over a working lifetime [1]. For a young investor, human capital is often the most valuable asset—much larger than accumulated financial wealth—and it is an intangible yet crucial component of a person’s total wealth [2]. According to ISTAT, the average human-capital value of an Italian citizen has been estimated at about €342,000 [3], highlighting its material weight. Ignoring human capital in financial planning means overlooking a substantial part of one’s wealth and overall risk profile.

From a financial point of view, we can treat human capital as an additional asset within an individual’s total portfolio [4]. Although it is non-tradable (you cannot sell or directly diversify it), it does have a risk/return profile that should be accounted for. Age, job stability and the industry in which one works affect both the value and the risk of human capital. Early in one’s career many years of income lie ahead (high human capital) but savings are limited; as retirement approaches, human capital shrinks while financial wealth grows thanks to years of saving and investing [2]. This implies that younger investors can take more financial risk because they are supported by ample, “insurable” human capital over time, whereas older investors should be more conservative since the labour-dependent share of total wealth is small. As shown by Bodie, Merton and Samuelson (1992), flexibility in work (e.g., the ability to extend a career or do overtime) offers a kind of insurance against financial risk, encouraging younger workers to invest a larger share of their financial wealth in equities than older investors [5].

Figure 1: Simplified trajectory of human and financial capital over the life cycle. In youth, human capital (yellow line) dominates total wealth, while accumulated financial wealth (orange line) is initially small and grows over time with saving. The red dashed line indicates total wealth (human + financial) in this hypothetical example.

As Figure 1 suggests, for a young individual most wealth consists of human capital, which is gradually converted into financial wealth as one saves and invests over a working life. Total wealth tends to rise over time if part of labour income is saved (in our example we assume an increase that keeps the sum H + W roughly constant). In general, the ratio between human and financial capital (H/W) varies along the life cycle: it is very high at the start (new workers with little savings) and approaches zero near retirement [6]. It follows that a young investor with high “wealth in human capital” and little financial wealth should invest relatively more in risky instruments (equities) than a mature investor close to retirement with little remaining human capital [6]. This is the principle behind classic life-cycle funds and age-based advice (high equity weights when young, progressively more bonds with age).

Another reason human capital matters: it acts as a risk absorber. If labour income is stable, an investor can take more investment risk, knowing that a reliable cash flow is available to cover expenses (and perhaps to buy additional financial assets at discounted prices in market downturns). Conversely, if labour income is volatile or uncertain, the capacity to withstand financial losses declines. In essence, the risk profile of human capital should guide the composition of the investor’s financial portfolio [7]. Elements such as job security, income volatility and industry cyclicality should be considered carefully within the overall asset allocation [7]. As a general rule, human capital should be “hedged” or compensated by financial capital: if one’s job is risky, the financial portfolio should be more conservative; if human capital is very safe, the financial portfolio can be more aggressive [8][9].

How to value human capital

Valuing human capital means calculating the present value of an individual’s expected future earnings. Practically speaking, it is a discounting exercise analogous to valuing a bond or an annuity. Formally:

where $T$ is the number of remaining working years and $r_d$ is an appropriate discount rate. The choice of $r_d$ is critical: for very safe earnings (e.g., a tenured public employee) one can use a rate close to government bond yields or the risk-free rate. For more uncertain earnings, add a risk premium, as with the cost of equity for a company. For example, a young employee with a stable salary of €30,000 per year and 27 years to retirement could have human capital around €810,000 simply by multiplying annual income by remaining years [10] (ignoring growth and discounting for simplicity). More rigorously, with the same €30,000 income and a 2% real discount rate, the present value of the next 27 years of salary is roughly €600,000–€700,000 depending on income-growth assumptions (here we assume no real growth, i.e., discounting only). A similar order of magnitude (several hundred thousand euros) applies to many workers, explaining why human capital is often the dominant share of total wealth in the early working years.

Note that the value of human capital declines over time: each passing year “uses up” part of one’s future earning capacity (and retirement draws nearer). Adverse events can reduce H abruptly (job loss, disability, death—risks against which insurance is advisable). Conversely, investing in education and experience can raise expected future earnings, thereby increasing human capital. Interest-rate changes also matter: a higher discount rate (e.g., higher market rates or greater perceived job risk) reduces H, whereas lower rates increase it.

Human capital and asset allocation: theory and models

Incorporating human capital into asset-allocation models means viewing the investor not only in terms of financial wealth but also in terms of the “implicit position” arising from work. The academic literature on portfolio choice with background risk tackles this problem. A fundamental result (Bodie, Merton and Samuelson, 1992) is that an investor with certain or weakly correlated labour income should tilt the financial portfolio toward risky assets more than an investor without labour income [5][11]. In other words, risk-free human capital acts like an “implicit bond” in the investor’s balance sheet.

In a one-period mean–variance setting with one risky asset (equities) and one risk-free asset (bonds), the optimal equity weight on financial wealth \(W\) when human capital \(H\) is present is given by the Bodie–Merton–Samuelson formula:

where $A$ is risk aversion, $\sigma_m^{2}$ the market variance, and $R_L$ the return on human capital (i.e., percentage changes/shocks to labour income), not the income level in euros. Key implications:
– If $R_L$ is uncorrelated with the market ($\operatorname{Cov}\approx 0$), the leverage factor $(W+H)/W$ amplifies the equity share on financial assets because H behaves like a bond.
– If $R_L$ is positively correlated (pro-cyclical income), the subtractive term lowers $w_{\text{equity}}^{(W)}$; if negatively correlated (counter-cyclical income), the term raises it.
– In one-period mean–variance, the variance of non-tradable income does not enter the optimal weights directly; only the covariance with the market matters. Multi-period CRRA life-cycle models add hedging demand, but that is a different (richer) framework.

On the other hand, if human capital is risky and correlated with financial markets, it looks more like an “implicit equity” in the individual’s wealth. For example, an entrepreneur whose income is tied to the economic cycle, or a worker with stock-linked compensation, has equity-like human capital. In these cases, theory suggests reducing equity exposure in the financial portfolio to avoid being exposed twice to the same risk [12][13]. The Enron case (salary and pension concentrated in company stock) is a cautionary tale: when the company failed, both jobs and savings were wiped out. Applying diversification to human capital means lowering exposure to financial assets whose returns are positively correlated with labour-income returns $R_L$.

A useful way to think about human capital is to ask: “Does my job make me more like a bond or like a stock?” [22] Teachers, civil servants or tenured professors have bond-like human capital; commission-based agents or start-up tech workers have stock-like human capital. In the first case, tilt the financial portfolio toward equities (since the “bond” comes from work); in the second, tilt toward bonds to counterbalance job risk [8][9]. The worst situation is double concentration in the same risk (high correlation), e.g., a petroleum engineer investing all savings in energy stocks.

Finally, consider practical constraints. Unconstrained solutions may recommend equity weights >100% (leverage) or <0% (shorting). In practice, retail/HNWI investors rarely use substantial leverage or shorting. Hence the unconstrained optimum is often brought back to 0%–100% bounds. The two numerical examples below illustrate these effects.

Practical examples: integrating human capital into asset allocation

To illustrate how to value human capital and incorporate it into portfolio decisions, consider two very different cases:

Example 1: A family with two stable incomes (one public-sector job, one permanent private-sector job), long-term horizon, low risk appetite.

Example 2: An entrepreneur with volatile income but high growth potential, whose human capital is more like a risky asset (equity-like).

For each example we compute human-capital value, the H/W ratio (Human capital / Financial wealth), optimal equity/bond weights in a simple two-asset mix, the impact of practical constraints (no shorting, no leverage) and a sensitivity analysis with respect to key parameters (correlation, discount rate, income volatility).

Example 1: Dual-income family with stable earnings, long horizon

Suppose a young couple:
– He is a public-sector employee with net salary of €30,000 per year;
– She works for a stable firm (large non-cyclical company) with net salary of €25,000 per year.

Both are about 35 and plan to work until 65 (30-year horizon). They hold €200,000 of investable financial wealth, currently 50% bonds and 50% equities (a balanced starting allocation). Risk appetite: moderate (assume a coefficient $A$ such that, absent labour income, a 50/50 mix would be considered adequate).

1. Present value of human capital (H): Treat both incomes as fairly safe—the public job is virtually guaranteed, the private job is stable with low layoff probability. Use a 2% real discount rate. Current combined income is €55,000 per year. Assuming constant real income, the annuity PV is:
   
   $$H \approx 55{,}000 \times \frac{1 - (1+0.02)^{-30}}{0.02} \;\approx\; 1{,}231{,}800\,\text{€}.$$
2. H/W ratio: H ≈ €1.23m, W = €200k ⇒ H/W ≈ 6.15 (≈86% of total wealth is human capital).
3. Optimal equity weight (BMS): Let $E(R_m)-R_f=5\%$, $\sigma_m=20\%$ (so $\sigma_m^2=0.04$), and $A=4$. With $\operatorname{Cov}(R_L,R_m)\approx 0$ (bond-like incomes):
   
   $$w_{\text{equity}}^{(W)}=\frac{W+H}{W}\frac{0.05}{4\cdot 0.04}\approx 7.15\cdot 0.3125 \approx 2.23 \; (223\%).$$
   This is the unconstrained optimum >100%. With 0–100% bounds and no leverage, the constrained solution is to move toward 100% equities on W (or at least a very high share). Despite sounding aggressive, overall risk remains moderate because most wealth is bond-like via H.
4. Constraints & intuition: The gap between the unconstrained target and feasible allocation narrows over time as W grows and H decays; continually high equity on W naturally raises total equity exposure as H/W falls.
5. Sensitivity: A modest positive income–market correlation would slightly reduce the equity share; higher discount rates (more job risk) reduce H/W and temper the equity tilt. Pure income variance alone does not change weights in this one-period MV model; only the covariance matters.

Example 2: Entrepreneur with volatile income and high potential

A 40-year-old tech entrepreneur earns, on average, ~€80,000 per year with high uncertainty; income is highly correlated with equity markets ($\rho \approx 0.6\text{–}0.8$). Financial wealth W = €300,000 (70% equities / 30% bonds).

1. Present value of H: Use a prudent real discount rate $r_d=8\%$, 20-year horizon:
   $H \approx 80{,}000 \times 9.8 \approx 784{,}000\ \text{€} \ (\sim 800k).$
2. H/W ratio: H/W ≈ 2.67 (human capital ≈72% of total).
3. Optimal equity weight (BMS): Estimate $\beta_L=\operatorname{Cov}(R_L,R_m)/\sigma_m^2$ from percentage income changes (or a sector proxy). The correction term $-\beta_L/(A\,W)$ can push the unconstrained optimum to ≤0. With 0–100% bounds, a very low equity share (often 0%) on W is sensible: the job already provides large equity-like exposure.
4. Constraints & hedging: Full hedging would short equity (e.g., index futures). Most individuals won’t; thus, hold safe assets (govies, IG credit, cash) and ample liquidity.
5. Sensitivity: Lower correlation permits some equity (e.g., 20–40%); if correlation were near 1, keep equities at 0%. Higher idiosyncratic income volatility argues for more safety/liquidity even if covariance is moderate.

Conclusions

Human capital is central to building optimal portfolios. In the Bodie–Merton–Samuelson one-period mean–variance setting, integrate it by: (i) applying the $(W+H)/W$ “leverage” factor when income is weakly correlated/safe; (ii) adjusting by $\operatorname{Cov}(R_L,R_m)$ (estimated on income returns) to reduce/increase equity when labour income is pro-/counter-cyclical; (iii) remembering that income variance per se does not change weights (covariance does). Multi-period CRRA models add intertemporal hedging demand.

Practically, this yields portfolios better aligned with real-world risk, avoids double-loading the same factor via job and investments, and improves total diversification. Rebalance as H decays or its risk profile changes.

References

Bodie, Z., Merton, R.C., Samuelson, W.F. (1992); Campbell, J.Y., Viceira, L.M. (2002); OECD (2012) Measuring Sustainable Development; CONSOB (2004) Portfolio choices in pension saving; Biagio Del Prete (2022), Divide the portfolio into three, without forgetting human capital; Investopedia (2022), Human Capital’s Impact on Investors.

[1] [2] [4] [7] [9] [23] [26] Human Capital's Impact on Investors
https://www.investopedia.com/articles/younginvestors/09/human-capital.asp

[3] [10] Human capital: what it is, how to calculate it and how to protect it (IT)
https://www.lucalecchini.com/blog/capitale-umano-definizione/

[5] ecb.europa.eu
https://www.ecb.europa.eu/events/pdf/conferences/131017/papers/Session_3_Fagereng.pdf?01933346814bac7658a7aab2d76a4c31

[6] [16] [17] [18] [19] [20] [21] [24] [25] Lec_4_Human_Capital_Background_Risks_and_Optimal_Portfolio_Decisions20190918104650 (1).pdf
file://file-R5jmXxCgu7FBv3QdjKTVtU

[8] Divide the portfolio into three, without forgetting human capital • Biagio Del Prete (IT)
https://www.biagiodelprete.it/dividere-il-portafoglio-in-tre-non-dimenticando-il-capitale-umano/

[11] Lec_4_Human_Capital_Background_Risks_and_Optimal_Portfolio_Decisions20190918104650.pdf
file://file-39aiidxoHeZVaqFk52tWD1

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[22] Tim Isbell online - Human vs Financial Capital
https://www.isbellonline.org/personal-finance/investments/asset-allocation-basics/human-v-financial-capital