Humankapital och dess plats i en investeringsstrategi

Intervju med professor Paolo Sodini från Handelshögskolan i Stockholm om sparande och humankapital

Jan och Caroline Bolmeson

2 oktober, 2022

Humankapital är enkelt förklarat värdet av alla framtida inkomster vi kommer få till följd av vår kompetens, kunskap, erfarenhet m.m. Även om det är svårt att ta på eller kvantifiera bör man ta hänsyn till det i en investeringsstrategi.

För något år sedan, i avsnitt 87, intervjuade vi professor Paolo Sodini från Handelshögskolan i Stockholm för första gången. Då introducerade han begreppet humankapital för mig första gången och en av mina insikter var: ”jag är en vandrande räntefond”. Sedan dess har jag tänkt på hans resonemang och diskuterat det mer än en gång i forumet.

Humankapital är nämligen lite klurigt. På ett sätt är det väldigt svårt att ta på och man kan lätt avfärda det som ett teoretiskt resonemang. Vad har man för glädje av att veta att summan av mina framtida inkomster till pension är t.ex. 10 miljoner? Men å andra sidan är humankapital förklaringen till att en 60-åring har svårare att låna pengar på banken än en 30-åring trots att 60-åringen har t.ex. bättre säkerhet i huset. Banken tar hänsyn till återbetalningsförmågan som i sin tur är kopplad till de framtida inkomsterna, precis som humankapital är.

Man kan även formulera sin ekonomiska livsuppgift att omvandla, eller växla, sitt humankapital till finansiellt kapital. Det vill säga att man börjar som ung med ett ganska högt humankapital, särskilt om man utbildar sig, och sedan över tid så kommer ju summan av ens inkomster minska ju äldre man blir (=eftersom man har färre år kvar). Då vill man ju att det ska vara ersatt av t.ex. pension och sparande.

Ett ytterligare perspektiv som togs upp i forumet är ju att man kan relatera till sitt humankapital som en resurs som man kan växla mot andra typer av kapital:

• Genom att utbilda sig ökar man humankapitalet
• Lön är växling av humankapital mot finansiellt kapital
• Finansiellt kapital kan växlas mot tid för t.ex. socialt kapital eller humankapital
  etc.

Humankapitalet – trots att det inte ”finns” – verkar ändå ha mycket påverkan på vårt liv. Därför är min åsikt att det är ändå något som man bör fundera på och ta i beaktning. Apropå det som vi alltid tjatar om att fokusera på det som gör skillnad. Få saker påverkar ens liv så mycket som humankapitalet. Då har vi t.ex. inte ens pratat om att man kanske som ung med högt humankapital bör ta högre risk i sitt finansiella sparande eftersom humankapitalet kompenserar för det.

Vi tar även upp de invändningar från er i communityn kring vad har man för värde av humankapitalet? Särskilt eftersom det t.ex. kan minska drastiskt om man råkar ut för en olycka eller liknande. Eftersom Paolo också är professor passar vi självklart även på att fråga om hans syn på sparande, investeringar utifrån ett forskningsperspektiv.

Vi hoppas att du uppskattar avsnittet!

Många hälsningar,
Jan, Caroline (och Paolo)

PS. Avsnittet är på engelska, men vi hoppas att det är okej. På bloggen kommer det en transkribering i veckan.

Innehållsförteckning

För dig som lyssnar eller tittar följer nedan innehållsförteckningen som också ger en känsla för innehållet i avsnittet:

• 00:00:00 Introduktion
• 00:03:59 Välkommen tillbaka Paolo Sodini
• 00:05:53 Forskningens mest relevanta tips för en småsparare
• 00:08:10 Ombalansera – försök inte gissa marknadens riktning
• 00:09:35 Få inte panik när marknaden är ner
• 00:10:40 Svårt skilja på volatilitet och trend
• 00:12:00 Svårt även för professionella förvaltare skapa värde efter avgifter
• 00:13:39 Effektiva marknadshypotesen
• 00:14:56 Vi skulle behöva 3500 års historik för att säga något med säkerhet
• 00:17:30 Svårt att skilja tur från skicklighet
• 00:21:00 Hur kan man tänka kring buffert?
• 00:24:00 Hur ser du på t.ex. guld och råvaror?
• 00:27:20 Fördel med index är att du slipper ombalansera
• 00:28:06 Intro till humankapital
• 00:29:30 Humankapital är ett diversifieringsargument
• 00:30:30 Alla har vi fått en stor tillgång med ett stort kassaflöde
• 00:33:30 Svårt att skatta humankapitalet
• 00:36:50 Humankapitalet minskar över tid
• 00:40:40 Pensionen är en del av humankapitalet
• 00:43:13 Humankapitalet är stort även i slutet av livet
• 00:44:40 Vilken typ av humankapital har du?
• 00:46:00 Risken med humankapital
• 00:49:20 Viss risk i humankapitalet är korrelerat med aktiemarknaden
• 00:52:00 Olika sätt att se på risk i humankapitalet
• 00:56:30 Rådet till barn: försök inte optimera humankapitelt
• 00:57:14 Svårt att värdera humankapital för det saknar marknad
• 00:58:30 Banken tar hänsyn till ditt humankapital
• 00:59.35 Schillers bok om marknader
• 01:00:50 Missuppfattning kring humankapitalet
• 01:04:03 Die with zero
• 01:07:30 Vi borde inte vara rädda att låna
• 01:10:01 Smeta ut konsumtion över livet
• 01:11:00 Växla mellan olika sorters kapital
• 01:14:00 Buffett: investera i dig själv
• 01:19:20 Diversifiera humankapitelet från det finansiella kapitalet
• 01:23:00 Aktiemarknaden är ett sätt att dela risk

Transkribering av hela intervjun

Jan: Thank you very much that you are doing this interview with us for the second time! 

Our previous discussion was very, very popular and I think the best comment came from my mom and she said ’Ah, it was very good. I didn’t understand everything you were talking about, but I really enjoyed watching him. 

If it’s okay with you I think that we jump right straight into it. I’ll do a short intro. 

Then we do like some quick questions. Then, if it’s okay with you, we can talk about the academia view of some investing, what are the important things for retail investing, and then we dive into human capital. 

Welcome back, Professor Paolo Sodini. You are a professor at the Stockholm School of Economics, and you’re as well the director of the Institute of Micro Data at SSE. 

You are also one of the founders of the European network of Household Finance. And as I’ve understood, your research focuses primarily on asset pricing and household finance. You have published several papers in top economic journals, and you have a Ph.D. from the Massachusetts Institute of Technology, also known as MIT. So, very welcome. 

The most relevant tips for investing according to science

Jan: You focus primarily on human capital, and that’s the main theme for this episode. We’ve gotten several questions from our readers. But for the new listeners, I would like to have some common views on savings and retail. 

How can one think about one’s finances from an academic view? Of course, this is not financial advice. This is just a discussion with subjective views. But as a person coming from academia, what would you say are the most important ideas for someone who’s never been in finance and economics? From the academic perspective, what would you say are the most important ideas?

Paolo: It’s very simple. There are three things I would say you have to do. You have to decide first of all, how much you should keep in safe assets versus risky assets. So, how much to keep in safe bonds or short-term bond funds, and how much to invest instead in stocks? 

We can take the most popular risky asset class, and that we will talk a lot about. Human capital has a huge effect on that. But obviously, it depends on your risk attitude in how much risk you’re willing to take. 

It depends on how much money you need for your daily life. You should make sure you have enough liquid or money in safe assets that you can use when you need to so that you can kind of carry on with your daily life. And also if there are some emergencies, you have enough money to face them. 

So that’s the first thing, how much risk you take to take. 

Diversify, diversify, diversify

And the second one, once you decide the fraction you want to invest in risky assets, I think the recommendation is always the same. 

It’s diversify, diversify, diversify. And nowadays there are fantastic vehicles through which you can diversify a portfolio. You can buy world index funds for a few basis points. 

I would try to focus on mutual funds that are offered by reputable providers. Execution in terms of bringing down costs and making sure that the fund really follows a diversified index are crucial. They also need worldwide access to trading platforms and so on. Large institutions have those possibilities. 

The third thing is rebalancing your portfolio. Don’t try to guess what the market will do. It’s extremely difficult to figure out where the market is going, and whether or not it’s the right moment to buy or to sell. I would say, just invest in an automatic way when the market goes down. When that happens, the share of your investment in risky assets is going to shrink. 

Then you bring it up to the share you want or have as a target. And similarly, when the market is booming, then the share investing risk in stocks will automatically increase simply because they’re valued more and more when the market is booming. Take it back to the level that you had. You can do this regularly. You can do it once per year, and there will be a big difference. 

I would that you can even rebalance every three months or something like that. 

Essentially, you will then buy cheap and sell when they are expensive. 

Since it’s so difficult to predict how the market is going, this simple rule will give you a lot without sweating and without making big mistakes. Don’t panic when the market is down, then the market is cheap. And don’t jump into the market or invest more when its valuations are very, very high, then there is an exuberance and people think stocks are fantastic rising in value. 

Well, if they go up, they will go down as well. Since it is so difficult to forecast, I think the best way is to use rebalancing. It is a passive approach to investing.

Luck or skill? Not even 3000 years of data is enough to know

Jan: I find this very interesting. In academia, and for investors that have invested for a long time, everybody agrees on the difficulty to forecast, you shouldn’t outguess the market. 

But if you then talk to the finance industry, or you talk to interested private persons or retail investors, they have almost an opposite view. What makes it so difficult to try to forecast or outcast the market?

Paolo: There is an enormous amount of volatility. The market goes up and down tremendously. It is extremely difficult to differentiate whether it’s just the expression of the uncertainty in the market, or whether there is a trend manifesting itself. 

Forecasting the market is not something an individual should try to do just by watching the news. Remember, whatever you hear in public, this information is most likely already incorporated in the prices. 

Of course, if you have privileged information, if you have the possibility of accessing tools that can analyze trends or information that is not obviously valuable publicly, then it might be possible. 

This is not something an individual private investor can do. Moreover, we see that professional managers are also not good at it. There is a lot of research in finance showing that active investing doesn’t add much. Or, that after all costs that are involved in actively managing the investment, in reality, generate lower returns compared to what you see in mutual index funds.

Caroline: Why do you think we keep trying then?

Paolo: I think that’s the way the industry can sell itself. 

There is a lot of interest in the opposite direction. If all these professionals just followed the recommendation I gave you, what would be in the newspapers every day? 

I think the recipe is simple, but it’s extremely difficult to prove that it’s the right recipe, the one I gave you. How difficult can it be to sell high and buy low? Especially, if we look at individual stocks. Maybe my friends tell me that actually, this is the year for that particular company. And I heard from another friend, who actually knows someone in the bank, that I should invest in gold. 

There are opinions everywhere, making it very difficult not to stray from one´s strategy. There is a fundamental law, which we know is not working 100 percent, but it’s still extremely powerful. That is ”the efficient market hypothesis”. It says that information is already incorporated in prices. 

So just think about this; this is a good company, and I should invest in it. Well, it depends on which price you buy. 

If everyone knows it’s a good company, the company is going to be highly valued anyway, and this will not give you such a high return. Maybe you are paying too much because everyone thinks it’s a good company but they are actually carried away. But also, some news that just came out publicly and maybe it’s not a full representation of the overall prospect of the company. So I think it’s a little bit how the industry is built and that is actually a problem.

Jan: One of the main issues is to try to differentiate luck from skill, for instance when you look at the historical performance of someone´s stock-picking. I have a faint memory that you said, when you visited us last time, that you need an obscene amount of time in order to be able to conclude something definitively.

Paolo: Exactly, the problem is that there is so much volatility in the market to really figure out what leverage you will receive from a specific investment or from the overall market even. It’s very challenging from a simple statistical point of view. 

So there is one thing I think I told you, or what I tend to tell my students. Let’s look at the world index. Since it’s so diversified, it has the least volatility, and we are talking about fifteen percent or something like that. And when we take all the data we have, which is about 150 years of data, then we really can’t estimate how much the stock market gives you above the bond market.

We could place it anywhere between four and eight percent. And of course, I mean, the estimate is about six, five and a half, something like that. 

But it’s not at all precise. In fact, I don’t know if it is four, if it is eight, and if you invest in your pension and receive four percent, you have one pension outcome. If you receive eight percent, you have a completely different pension outcome. So we are not talking peanuts here. 

Now, let’s take a mutual fund manager, and let’s say that this person has the typical pension. This person has a lof of experience, has been out there for ten years. I’m going to try to see if this person can beat the benchmark at ten years. 

There is a statistical fact that is a little bit shocking: If I would like to know how much stocks earn over bonds, it is between five and a half and 600 percent. 

So I just want to have one percent bound around six percent. I need 3000 years of data with that volatility. So we would need to go back to Egyptian time. Of course, the stock market, first of all, didn’t exist back then. Second, it’s probably so that what happened in Egyptian time and Roman time isn´t representative of what is happening today. So you also have this tradeoff between the fact that the economy, the world, and our society changes dramatically and taking data that goes back a long time, maybe is not representative of what’s happening now. 

So that’s a curse, but this allows people to quote very good performances that in fact we can’t really statistically say whether they are good or not. If statistically, I can’t really say whether the fund manager is good or bad, it is extremely difficult to distinguish a skill versus luck for this reason. 

The next best thing is to explain that you have something really good in your hand. So you follow a strategy that is winning, that the reason as a class is going to do very well for whatever reason. Hence all the talking and all the discussions and the different products that we see in the retail industry and in the media. 

Now, I’m not saying that one can build more sophisticated portfolios than just diversified early balance. You should take care of inflation. You might have a mortgage, you have an interest. There are a lot of things you can do but they are not in the vein of this is going to be the next big thing, or now the market is going to tank. 

Just think about what happened during the Covid. We had a huge drop and everyone was in a panic. People thought that the world was going to be different forever. And then came the best performance ever afterward. I hate to say this, but this is just an example. I mean, it doesn’t mean anything, but it’s kind of representative of what we know is in the data. I´m really orthodox on this. But I think that when it comes to retail investing, I think it’s fair to put it this way. Otherwise, people go after all sorts of things, and then, in the end, they lost a lot of money.

If you try to find the best tree, you forget that the whole forest is growing

Jan: Did you read the Bessenbinder study? I think it was some Dutch guy, a Dutch professor. He asked the question; Do your stocks beat bonds over a long time? And I think his result was two or four percent of all stocks on the SOP500 over 70 years stood for 100 percent of the equity premium. It was really, really just a few companies, which also were in favor of owning the whole haystack (all stocks) instead of trying to look for the needles (star stocks).

Paolo: There is a nice analogy that I like a lot. It’s not mine. It goes like this; if you try to find the best tree, you forget the whole forest is growing. It’s much better to invest in the whole forest rather than picking the wrong tree that might actually for some reason fall down or have some disease or whatever.

Pointers to creating an emergency fund

Jan: Exactly, I would like to walk back to also the emergency fund you mentioned. You said you should divide how much to put off for emergencies, or a buffer fund. Are there from academia any pointers on how one should think about that?

Paolo: Yes, there are two aspects I would say. The first one is that you should decide what is the minimum for you. Many things can simultaneously go bad in your life, you need to survive for a certain amount of months, need this amount of money, and so on.

So this means that you have a sense of what it means for things to go really badly. So, you might have unemployment insurance and so on and perhaps growing benefits from the job, or some type of floor to how much you can earn. There is one discussion about the needs if you instead might lose your entire job without this type of parachuting. That is a completely different discussion. But that’s the first thing. 

Then you have to consider that things might break, right? Let’s say my car breaks, and I really need it. Can I stay a month without it, or do I need that money to repair it? So that’s the first layer. 

The second layer is what we call habit. So you grow accustomed to a certain standard of living and you have a series of expansions. I would call them consumption commitments. This can be of all sorts of things. I want to have a certain house with a certain style. I don’t want to live in a certain neighborhood, or I don’t want to downsize. I need to provide for my family. All these types of arguments. This is about making sure that you have enough money to maintain your standard of living. And this obviously, affects how much you want to put in risk assets versus keeping in safe assets precisely because you want to be safe enough from that point of view. So I would say these are the two criteria but it’s very individual, especially the second one. 

So it’s difficult to give a general rule on how much you need for three months or a salary-based buffer. Perhaps in Sweden, if you are unemployed, then yes. But it’s something you have to sit down and think about having these arguments in the back of your mind.

Jan: I normally say it’s very different if you’re single and a student or if you have a house and a family and two kids. 

Should gold and other commodities be included in my portolio?

Let us take the two last questions before we go into human capital. As I understand it, the academic view is in line with what we talked about; owning the whole forest. We got two questions from our forum; Do you have an opinion about assets that are missing a natural dividend, such as AG gold or commodities or natural resources? Would you count them into the Efficient Market Hypothesis? Are they included?

Paolo: I think you should diversify across, so there are various asset classes. 

So you have commodities, you have the stock market, you have private equity, for example, and you have real estate, so there is a lot of stuff you’re shooting for. But if you really want to diversify your portfolio, then you should go all over the place. 

Now, one way why this might not be very extremely important, or why you don’t need it necessarily, is that in the stock market, you have a lot of companies whose return is representative of those as the classes. 

So you have commercial real estate companies, you have oil companies, you have all sorts of companies that actually rely on prime materials. And so you might want to have investment companies that invest in private equity. By investing in the stock market in them indirectly you have access to these other asset classes. 

So one might argue as a first step that investing in the stock market is really important. And then, the second issue, is that you have access to all this type of stuff through the stock market. These companies actually rely on that the alternative asset classes will work in those fields. The second step is to decide in which proportion to put these things together. And then, the stock market is easy because companies have a certain market cap that is kind of represented how well they’re doing. 

And there is a market portfolio. So if you just invest in the world index, then you are all set in that sense. How much should I invest in gold? It becomes difficult to decide, but also be too precise on how much to invest in each company it’s not super crucial. 

There is a famous paper by Ramal. What is fascinating, is that he just tests the “one over end rule”. He takes several last classes, he defines them in very different ways, and then he builds a portfolio of one over end. So if he has three asset classes, one-third, one-third, one-third, five, whatever, then it shows that this actually tends to do much better than optimizing your portfolio, finding the optimal mean-variance solution in each period. 

And the reason is basically there is so much noise on the returns over which you optimize that. At the end of the day, by fine-tuning, you do worse than just having a strategy in which you don´t trade that much, and so forth. One advantage of investing in an index is that you don’t need to rebalance it across as the class. So if you have ”one over-end rule” and one class becomes too large, then you have to rebalance your portfolio. That’s done automatically in a market if you invest in the overall market. So the market in a way chooses how to allocate money. But should you invest a lot in gold right now, or not? I mean, personally, I don’t know. And I think it’s very difficult to figure it out as I told you before.

Intro to human capital

Jan: Okay. So let´s go into human capital. For me, that was a real eye-opener three and a half years ago. And it has been following me. 

I think you said that households can count on two main type of resources over their lifetime. The tangible wealth, which I understand can be funds, stocks, real estate, the house you live in, et cetera. Accumulated from the savings and inheritance. 

And then you have the human capital. I think you defined human capital as the main source of lifetime income for most households. And its typically non-trade careers. Why is human capital such an important concept?

Paolo: I think we all agree that we shouldn’t take assets in isolation. When you build the portfolio, you put together assets that have different cash flows and these cash flows interact with each other. 

Whoever is going to build the portfolio for you is going to take into account the overall interaction of all these assets, and overall cash flow comes out from them being in the same portfolio together. And basically, that’s the idea of diversification. By diversifying, you reduce risk dramatically, but you don’t have much of an impact on returns. So that’s kind of the idea. That’s a big win-win situation that you have by diversifying your portfolio now. 

So if we agree that when we invest, we need to take into account the combination of the cash flow of our investments. But we should not forget that all of us are endowed with an asset, which is human capital. It has probably the largest cash flow that we receive over the life cycle, which is salary earnings. 

If you think about it, when I decide how to invest in a financial asset, not taking into account how the cash flow of my investment interact with the one that I have, that I will receive for sure by working, it’s something that fails the basic principles of finance by a large magnitude. And this becomes particularly important because of the earnings, how much you’re going to earn by working. It’s an enormous amount of money and it lasts for a very long time throughout your life, in fact. And of course, you work until 65, but while you work, you also, save for a pension.

All the money you receive for pension is coming from your work as well. So the whole life cycle is the only thing to grasp. To understand why human capital investment is an investment. When we build our portfolio, we need to consider how all these assets, and cash flows, interact. We should also consider how they interact with the cash flow they receive from working, which is something that we have for sure, and it’s huge.

For most people human capital is a good idea, but what do we do with it?

Jan: When I try to explain this to people I’m not doing as good a job as you. For me, it’s interesting knowing it, but what do I do with it? Because people who ask me say, ’This won’t affect my investment decision because I can get ill or unemployed. Maybe I can lose my human capital’. For most people human capital is a good idea, but what do we do with it?

Paolo: That’s a very important question. And also I’m super happy to talk about this again in this podcast because since last time we learned a lot in academia. There are very important advances in the last three years that I would like to share with you. 

Which also changed the way I approach how to consider human capital in my investment portfolio. 

First of all, we need to remember what human capital is. Human capital is basically the value of all this stream of earnings that you will receive. It is extremely difficult to evaluate because you have to forecast how much an individual is going to earn throughout his or her life. 

And then you need to discount it today and need to find the active count factor. There is literature trying to do that. There are various ways to do it. So for a single person, really the estimate could vary wildly, but we know it’s very large.  For someone that finished college education in Sweden, I would say that it’s more than 10 million kronor when you are about 25 years old. 

And then even it is difficult to quantify. We know it’s a lot for most people compared to the liquid assets they have, especially at the beginning of their careers. 

It’s a lot of money. It’s a very large asset and naturally because you earn a lot over your life cycle. It’s difficult to formulate, but we know how it evolves over time. And so just think about it, as you grow older, you have fewer and fewer years to earn money in working life, which means that the value of human capital tends to shrink over time. 

In the beginning, it might increase because your salary goes up. So basically you take the present value of higher and higher wages, but then eventually it has to go down. So over the life cycle, you typically see human capital might go up until you are 30 or something. It depends on how steep your earning profile is. But then it has to go down slowly. 

And then if we take say it is 10 million when you are 25 or 30 as an estimate when you’re 65, you have about 3 million left. Okay. So it is still substantial for a lot of people even later in life, but we know it has this kind of declining pattern for sure.

The Swedish pension system is compensating for a declining human capital

Jan: Can I try a thought on you, Paolo? I have been thinking about human capital for three years now. I will try to illustrate this for our viewers, I’m going to share a graph. This is a very basic normal discounting, and to make the graph I took a normal Swedish person. I’m going to show you this. So this is 40-year-old Swedish Anna. She has 25 years until her pension starts. And we said she earns 25,000 kronor after tax. And then I took a discount rate of three percent.

Paolo: And then you assume that she will earn 300,000 kronor per year.

Jan: The same salary her whole working life.

Paolo: This is why it just goes down. If the salary would go up, then you would have at the beginning it goes up and then it goes down.

Jan: And I took the three percent because I read somewhere that insurance companies when they discount use between one and three percent.

Paolo: It’s very difficult to figure out what the rate is. It depends from person to person. And then you get these types of numbers very easily.

Jan: So we can say, we don’t know if it’s 5 million kronor, but for the sake of argument, I would say it doesn’t really matter if it’s five and a half or six or seven. Is that correct?

Paolo: The only thing I would say here is that as she earns this 300,000 probably there is a bunch of money that goes into a pension. Which they actually earn, and you haven’t included here. That’s why it goes to zero at 65. But you should take that into account too.

Jan: That was what I thought of later because she gets the pension capital which actually kicks in as an income after 65.

Paolo: That should be included already in the five million at the beginning, you should discount the whole thing all the way to 85.

Jan: Ah, okay. This is perhaps wrong, but what I noticed is that if you add the pension capital from the beginning as I did here, then we get financial capital and the human capital is approximated in the Swedish system pension system. 

And this, for me and in our forum, was a big surprise. Because of how the Swedish pension system is designed with the four and a half percent – the tjänstepension, the income pension – these eighteen percent compensates for the decline in human capital.

Paolo: But to me is all human capital. 

If you go to the first graph. That black should be included from the beginning to the blue. The money that we receive for pension is not coming from out of thin air. They’re coming out of savings that are earned through your labor income. 

Instead of earning it now, you earn it later. But it is still labor income. We have designed a system in Sweden in which the amount of money they have to put in their pension, is decided like this. That’s not true for the US for example, where it’s up to each individual how much you save for a pension.

Jan: That’s what I try to illustrate here. And it’s not that important because we have podcast listeners not watching the graphs. 

But, I was thinking about, maybe this is wrong, this is why I’m trying this, or just throwing it at you; Could one say that one of the financial goals, or economical goals, in life is to convert your human capital into financial capital? Because if your human capital is labor income as in the salary you get for the work you do, then as your human capital declines, your financial capital increases. 

And as we can see here in the Swedish pension system, somebody should get the Friday cake because they manage to keep it almost at the same level throughout life, given that they work and all the other assumptions are true.

Paolo: I’m not sure about these products you show me because I think I would rephrase them. 

Pension for me is part of human capital, so it would look differently. But definitely, that is exactly what is happening. 

You have human capital at the beginning which is the present value of how much you’re going to earn. And as this decreases over time, the amount you save also in your pension increases. And that’s kind of your financial capital or liquid capital, which is part in pension, partially in current savings. 

Because as financial wealth becomes larger and larger, the role of human capital in your investment decision is going to be less, and smaller and smaller. In fact, maybe we can go to the recommendations. This is absolutely crucial. This is exactly what’s happening. 

The alternative is to actually not save. Then you only have human capital, which will decline forever if there is no pension system, and you are not forced to save. You will end up at 65 without anything to live on.

If I take into account the human capital, my savings doesn’t seem matter that much

Jan: I want to show you one more thing. Maybe we can talk about the thought process. 

So this is from Avanza. They sometimes publish the average net worth of their individual savers throughout different years or different age groups. And I understand this is not the whole capital of the people, this is just what they have at the Avanza bank. But these are the only figures I could get on wealth in different age groups. For me, it was very interesting. When I put this into relation with human capital, until you’re 55, if we look at the amounts that people have at Avanza, the numbers are totally insignificant compared to the human capital.

Paolo: This is the argument I was making before. Even late in life, it’s a huge asset that you have. And so you have to take it into account when you decide how to invest your money.

Jan: For me, that was like the big takeaway when we met last time because I tried to save more. I was thinking that I shouldn’t have all my money stocks because I should have some bonds etc. You never know what happens. I want to protect myself from volatility and so on. But if I take into account the human capital, my savings doesn’t seem to matter that much.

Paolo: It doesn’t matter. If you want to have some ideas of how much wealth people have over time over the life cycle, we have good statistics back up to 2007. Then, unfortunately, they stopped collecting the data. And I have some papers on wealth distribution too. 

So you can see there how much money people have. And I think we have some graphs by age as well. At least I show it in my course. But as human capital goes down and you save especially given how much you’re forced to save in pension, your financial wealth increases dramatically. 

And so then, you are left only with financial assets basically. And this means that how you invest those money becomes very important later on. In the beginning, it becomes very simple. When you have almost only new capital, then the only question you have to ask is which type of human capital do I have? This will give you guidance on how to invest the little money you have in your financial wealth, which over time will grow. 

Once we understand that the human capital is large, I think we made this point through your graph. It is still very large in your fifties. The next question is what should we do about it? And then the issue is what type of risk does human capital entail? 

Because this cash flow is not that you earn it for sure. There is unemployment, a career can go well, it can go badly, and there are all sorts of things that happen. 

We have actually changed our view in academia when it comes to risk in human capital, compared to when we talked last time

And how about the riskiness you have in human capital, how does this affect you? How much should you invest in your tangible assets and your portfolio building the financial world you’re accumulating over time? 

And as this world becomes larger and larger, obviously human capital becomes less important, but you have to consider the two things together. So let’s spend a little bit of time thinking about the risk you have in human capital. We have actually changed our view in academia when it comes to risk in human capital, compared to when we talked last time

If we take the average person and look at the labor of our earnings over the life cycle, then we try to understand how they are correlated with the stock market. The answer is overwhelmingly almost nothing. 

So most of the risk that you have in your earnings is idiosyncratic. It is something that happens in your sector, it is something that happens to you. Because you might get sick or your skills might become obsolete and so on, and so forth. But they’re not correlated with the business cycle or how the stock market changes over time, which made me, last time we met, conclude what you said that you are a “wandering bond”. Basically, most of the risk is idiosyncratic.

Things can happen, but we thought that it really doesn’t correlate with the stock market. So you have to consider, you have a lot of money that gives you cash flow that is uncorrelated with the market. You should invest aggressively in the market, in the stock market if you have a lot of human capital, which means early in life, but as we said it can be very large until you’re 50 or whatever. 

Okay. So now what happened, is that we understood that we were measuring risk in the wrong way. So this is also because now we have data, especially in the US on wages, very precise data on earnings. It wasn’t there, we used to have information only from surveys. Now in the US, and in Sweden for a long time, we have information on earning, it comes from administrative sources in the US the tax system. And people actually look into much more detail of the type of risk that earnings entail having an enormous amount of observations and so forth and going back in time for many years. 

There is a skewness that moves around in the labor market, and this skewness is highly correlated with the stock market

What we find out is that actually there is a lot of skewness, as we call it in the labor market. This means that when times are good, more and more people earn a lot. When times are bad, more and more people tend to lose their job even or earn much less. 

The average doesn’t get affected that much. But there is the skewness that moves around in the labor market, and this skewness is highly correlated with the stock market. We call it cyclical skewness. This is academia in a nutshell, it took us forever to come to an obvious conclusion.

Basically, when the stock market goes down, or when the business cycle is bad, then we see a lot of unemployment. Okay? So that’s called right skewness. And when the stock market goes well, we see a bunch of people earning a lot of money. More and more people earn a lot of money. 

And this type of risk moves a lot with the stock market. And in our models, we were not considering it. We did not consider cyclical skewness, or skewness in the labor market, and how the resources redistribute the labor market. How it moves a lot with the stock market and with the business cycle. We did not consider that we were just taking the correlation. But the correlation takes the average guy, and the average guy is actually not that affected. 

So it’s really a different way of thinking about risk. It’s a bit obvious now, when it is exposed.

Jan: It´s always in hindsight. 

The risk in human capital changes dramatically from one labor sector to the other

Paulo: And then another researcher wrote a model where you try to find out what is the optimal behavior and how you should invest. Once you consider taking to account cyclical skewness, this new source of risk that we discovered, has devastating effects. Then you’re not anymore a wandering bond. On average, when you are young, you shouldn´t be as aggressive. It is actually a bit of cyclical skewness going around. What is important is that this cyclical skewness changes dramatically from one sector to the other. The risk in human capital changes dramatically from one labor sector to the other. So you are not a wandering bond if you are in construction, it has a lot of cyclical skewness. The public sector has none.

Now if you have a low of capital, and your human capital is very risky in the sense that I told you, then you shouldn’t be as aggressive in investing in the stock market when you’re young. 

And similarly, if you are in the public sector and the sector that’s very stable, there isn’t much unemployment going back and forth, and depending on what happens in the business cycle, once you’ve taken care of your buffer, invest aggressively in the stock market because this human capital you’re sitting on is very, very safe. 

And we would prompt you to invest aggressively in financial wealth. As human capital goes down, the bond part of your total wealth goes down and so you should reduce your investment risky asset in the financial part of it. Even if you’re a wandering bond. And if you’re in the construction sector, you should be careful and as your human capital goes down, maybe you can become more aggressive actually in the stock market if you have saved enough money. And then based on that human capital is enormous at the beginning, and it goes down towards the approach of retirement.

Jan: How should one think about insurance contracts for instance, such as life or accident or health, or things that affect the human capital? Because I think if I get unemployed from the construction work, then it’s maybe a better option to choose unemployment insurance.

Paolo: Absolutely, all this depends. It is highly dampened if you have unemployment insurance. If you insure your mortgage, things like that. And the more cyclical skewness you have in your sector, the more you should cater to this type of insurance. 

You know it’s going to make your capital safer and then we go back to being the wandering bond. 

But I actually have a paper that is now on review in one of the top journals, together with my co-authors. We actually try to see in the data if people feel that they shouldn’t be as aggressive if they are in sectors that have a lot of cyclical skewness versus sectors that are rather safe in that sense. 

And we use various measures of risk. We use the correlation as we used to do, which varies a little bit across sectors but not dramatically. We use the cyclical variants, which is how much dispersion there is in labor in earnings all the time in a certain sector. 

People in risky job sectors tend to invest less in the stock market

Paolo: We find that cyclical skewness actually has an enormous effect on the probability that people participate in the stock market in a certain sector. So if you are a swede in a sector that has low cyclical skewness, you actually tend to invest less in the stock market as we would’ve predicted. And I think it makes sense because we have a sense that you’re sitting on something that your earnings are not as safe as if you would be in the public sector. And then this prompts you to take less risk on the stock market. So it seems actually people have gotten this, so now we have it also aligned with academia.

Caroline: How do you know which sector you’re in?

Paolo: We’re revising the paper and we’re going to make the list in which we have thirteen sectors plus three levels. You also have to think about your level of education. So it can be in a very safe sector, but you have a high managerial position. You might actually be fired very easily and so forth.

Caroline: Parents that tell their kids to go safe and become a doctor or dentist, were right all along?

Paolo: Well, in terms of having a safe job, yes! I am not saying that you shouldn´t take risky-sector jobs at all. People should do what they like to do and have a talent for. Many things come into your job; personality, skill, education, etc. It is embodied in the ability to earn money. The first thing is that you should match with the job that you are done for, a job you want. A job you study or you burn for, that’s the first thing I would say.

Caroline: This kind of study can help us understand better how to manage our finances in the life that we have chosen.

Paolo: Exactly. This is what you should do with your finances. And this is another thing about human capital, it doesn’t strike as an asset because it doesn’t have a price, and there is no market for it. That’s why it’s so difficult to value it. 

In the large part, you’re stuck with it and if you want the price to acquire human capital, how can you do that? It’s not really that you pay money and then you have human capital in your portfolio to look at. You might pay tuition in the United States, for example, you have to pay a lot of money to get a good education, but it’s through your education, it through your learning on the job, it is through how curious you are when you work and so on. 

It’s very intangible how you acquire it, the price is in terms of what you didn’t do otherwise. It’s in terms of opportunity cost. Compare it to other assets where you just pay price by the house, you pay and you get the house, you buy a stock, you pay, you get the stock. But in terms of providing you with a cash flow, which is the longest we have in our life cycle, it’s exactly like any other asset. And that has to be considered when you invest.

Jan: If you go to a bank and get a mortgage then they look at you as a human. They don’t say to us that we are valued in our human capital, but they ask things that hint about it; Do you have steady employment? What is your salary? They have your cost. So they actually do the calculations.

Paolo: The reason why you can take that loan and the mortgage is that you have this cash flow that is going to pay service in it over time. And for them, it’s crucial to know that you have that on top of it, you have collateral. So that’s another thing human capital’s difficult to collateralize. 

I think the only setting in which you do that, is when you take a student loan. But apart from that, you need other collateral. But you do have that human capital and the world is not collapsing even though you’re sitting in a law of that precisely for that reason.

Jan: I read that 4000 years ago, you actually could collateralize your human capital. 

Paulo: Yes, if you could sell your human capital, that would be it. Close to slavery.

Speaking of another thing. Think about singers. When they start they build their image and have their label, and the label takes a part of the artist´s income for as long as the contract is valid. That is taking a part of their human capital. Also, football players can be thought of in the same way.

Human capital is not the same as self-worth

Jan: This is one of the most common arguments when I talk about human capital: I feel that some people mix up human capital with their self-worth. 

This is very strange because as I said, the human capital declines over time because I’m looking at it strictly from the future income streams, and they feel “but when I’m 55, I have all this experience, I have all these contexts, I have all these skills. So I feel more worthy and I’m 55”.

Caroline: Yes, that was something I said.

Paolo: And indeed, if you do, and a lot of people do, they have a very high salary.

So it’s just the fact that they have little human capital, they have few years to work still. That’s the only reason. But they are earning a lot because their productivity is extremely high precisely for all these reasons. 

So it’s not how much your productivity is worth, is the present value of whatever you’re going to earn later. In the future, unfortunately, we all age and we all going to die, So it has to decline over time. 

But aging life quality and life expectancy increase dramatically, and we are also becoming more and more aware of the type of skills that you can develop over your life cycle. So when you’re young, you might have lower analytical skills. When you are in your fifties, then you have more of an ability to synthesize, summarize, communicate, and things like that. I think as we are more aware of that, we can also make the best of our skills over time. For a lot of people, it means they don’t need to retire that early. I mean, I personally am really not looking forward to retiring in 65. And still, human capital is going to decline, but you might have a lot of money because you’re very, very useful and you work a lot for society.

Jan: And I always try to do not to mix up that this is a strictly financial definition, but it’s funny how people were protesting about the concept due to that.

Paolo: It’s provocative because you talk of human capital but we have to really just think about what the value is now. All the earnings you still going to generate as you, as you age, and this includes deferred earnings, which is pension. That’s the right concept to think about and the riskiness of that cash flow of the value of capital. These are the right concept to consider when you think about investing, that’s all.

Jan: Yeah. I think we’re going to take just a few more questions. 

Paolo Sodini´s comment on Die with zero

So, this has been a big discussion in our forum. The discussion, for me, is kind of related to human capital. There is a book written by the author Bill Perkins. 

His concept is to Die with Zero. And he said that a lot of us are accumulating financial assets. And if you look at the graphs on net worth, it tends to increase over time until you die. 

We had this discussion with my mom who’s 70 and she’s still saving. I was like, you’re 70, you have your pension, you have your house without the mortgage, what are you saving for? Do you know if there is some data, or view, in academia on this?

Paolo: Why would you leave money on the table once you’re gone? First of all, because you really care for the future generation. You want to leave money for your children, you want to leave money for society, you might leave money for charity and things like that. And that’s just something you want to do. And that’s it. Okay. So, you know, if you want to do that, keep saving. That’s very important to you and you should do it. 

If we take that part of saving away, then really you should only save for the consumption you’re going to get yourself. And the basic recommendation for saving is to keep consumption as stable as possible over time. Of course, as you age, you might not get as much out of your money. 

Perhaps, you can’t travel as before or you can’t do a certain type of sports as before, and so you might want to save less for those times because you are going to enjoy it less in a way. 

But to the extent that you can enjoy consumption, broadly speaking, or your standard of living if you enjoy life, obviously you should save considering that what you save now, you can’t enjoy now. 

Someone else you leave the money for will enjoy it, but if we take that away, you will enjoy it later. So don’t save if you don’t want to leave it, if you’re not going to enjoy it later, and if you don’t want to leave money to someone else afterward. 

It’s like Robin Hood, but the other way around

It’s very simple. Borrowing means taking resources from the future to now. I anticipate future income to now, in order to buy the house. And obviously, I will enjoy less of this income because I need to service the mortgage. Saving means taking resources now and moving into tomorrow. So why do you move it to tomorrow, either for yourself or for the future generation? That’s the way to think about it.

Jan: I don’t know if this is coming from me getting older and getting more experienced, but a couple of years ago I always said; You should save this percentage each month. And then I realized, a young person is going to make more money in the future. Saving now is kind of stupid because it’s like taking money when you don’t have them to give to yourself in the future when you have a lot of money. 

It’s like Robin Hood, but the other way around, taking from the poor to give to the rich and should be the other way around.

Paolo: I completely agree. I think that we shouldn’t be scared of borrowing if this allows us to have consumption more evenly spread out our life. I mean, not a little bit, but I think it’s an issue that but probably an unavoidable one, that we have so much money coming in because of human capital and we can’t borrow against it. 

We can borrow it once you buy a house. I mean, as long as people don’t get themselves over-levered in the sense that they have leverage that they can’t actually service over time. I think that actually, it’s good that you can keep borrowing as the house appreciates in price in order to finance your consumption. Because that’s one of the few ways we have to bring money from the future to today actually, to have housing.

Caroline: Is it a certain type of consumption you’re talking about, like experiences, or is it any kind?

Paolo: That is really up to you. I think that’s when you have so much life in you and so much energy and you’re young and have to wait another 30 years before doing the trip of your life or whatever, it’s a bit of a pity. 

And I think we’re learning a lot about labor income profiles. It’s how labor income evolves over the life side, which characteristic, which risk it has. There is a lot of research coming out right now because we have so much data. Perhaps when we have a better sense of labor income over the life cycle, then it might become easier to lend to people just out of that. 

And so they could anticipate consumption. I think it would be useful, and probably at a rate that is less reasonable than credit card rates through the roof and they become extremely expensive.

You can increase your human capital by exchanging it with other types of capital

Jan: Exactly. Also just a side note, this was a comment from the user in the forum, Pareto. He said that he, after the last episode with you, started to think about exchanging these different kind of capitals. 

Everybody can exchange human capital for financial capital. We call that a job. You can choose financial capital for human capital, which is education. So you can invest in your human capital by paying your financial capital. And then you can get financial capital to social capital, I can pay for not going to the job to go to this course, and then I’m going to meet people there, which increases my human capital.

Paolo: I love that. I think it’s exactly the right way to think about it. And people should think about, especially in Sweden, is that you can always go back to school and you don’t need to pay much or even nothing actually to upgrade your skills and have a lot of friends. 

They went back to take some courses in engineering to upgrade their skills. It is never too late to go to build up your human capital in order to change your prospects basically in your lifestyle. 

I think it’s an amazing thing about this country that you can do that without taking a loan and all of that. And I think it’s a very important mechanism against social inequality, for social equality, for social mobility, for people at any stage in their life to move around and also upgrade their skills. 

When I started to work, you had this idea coming mostly from my parents; You get your job, you keep it for your life. I mean, there is no such thing for sure. Things change so quickly, and you constantly have to inform yourself. And by the way, you have also the possibility of informing yourself, of learning a lot through the internet and so forth. But the problem is there’s such a vast multitude, it is difficult to choose what is right and what is wrong, what is true and what is false.

Caroline: Yeah. I was thinking about this social capital that you incorporate into your human capital, you don’t even have to pay for it sometimes, as you said, with the education in Sweden, I mean, you can enroll in some charity, or I’m going to into scouts now, for example, and I’m getting all these resources. And I meet a lot of people and so on. And I wasn’t thinking very much about this from this perspective and it’s even free.

Paolo: One big question is why big cities are becoming so important. If you think about it you start having this New York, London, these huge cities that keep attracting people, and they become almost a nation in themselves. They’re not even representative of the country they live in. And I think part of it is that you have an enormous opportunity to build up your social capital, which then transfers into your human capital. So putting minds together is a huge element of very high productivity and innovation and entrepreneurship and so on and forth.

Jan: I watched the Berkshire Hathaway annual meeting this year with Warren Buffet, and he got the question from his audience; What’s the best investment you can make? And he gave a long answer about investing in yourself, in education, and I think he actually said increasing your human capital. Because that’s a skill set in the market downturn, nobody can take that away from you.

Paolo: The moment you enhance this cash flow forget about personal gratification and everything, which I think is probably the most important factor. But you have generated a cash flow and it’s a huge cash flow. People obsess about how to invest in the stock market, but you have that, the human capital, which is enormous.

Jan: Yeah. I also read another book that said when you’re starting your investing career, ignore what you invest in stocks, because that’s going to have such a marginal effect, keep increasing your skill to earn more money, because over time that’s going to increase.

Paolo: I mean, this is a little bit one of the arguments for why you should just diversify, rebalance. So you don’t have to spend time on that. And still, you can save and it’s going to go well. And probably is the best thing you can do anyway. And then you have all the time in the world to actually invest in your human capital, in your career, in your skills.

Jan: The last two questions: is there something you think we should have asked about human capital? Is there something we missed?

Don´t put your savings in the same sector as your job

Paolo: There is one thing more to remember, which is a diversification argument.

One effect that human capital has is how much risk you take in your portfolio. Whether you invest in stocks at all, even. 

And that depends on the nature of this at least our best guess right now is cyclical skewness seems to be very important. That’s one side. But the other thing is diversification. It is a little bit of a mystery to me why we don’t see those products being available in the market; It’s this, if you work in construction, you don’t want to also invest in construction. 

If construction goes down not only you’re going to lose your job, the value of your savings is going down too. There is an argument for tiling your portfolio away from fully diversified to avoid the risk that you have in your human capital. 

People tend to think; Oh, I know how to invest. But I would say diversify. Maybe take a little bit of money where you pick your stocks. And the reason I think that it’s very difficult to quantify is the value of tilting away. 

And I think partially it’s because this correlation was so low, we didn’t think it was important. But now maybe with cyclical skewness, we can quantify a little better what the value is of putting your saving away from your human capital. It means your savings should not be invested in risk that is correlated to it, for example, in the same sector. But that’s in principle we should do difficult to do. There are no products out there, that actually help you to do that, but it’s worth thinking about it.

Jan: It’s actually interesting that you say it because we had that discussion in the forum about not putting your human capital in the same bucket as your financial capital. If you have stock options, great, take them, but sell them when you can. So you’re not dependent on that. I think we saw in the US with Enron, people lost their jobs, their careers, and they lost, and their pension. So this is what I love about academia, and because it’s actually a lot of common sense.

Caroline: I also like very much with academia that you finally have words for phenomena. You might be intuitive for us, but all of a sudden you have data and you have the words for it…

Jan: Distinctions, you mean?

Caroline: Exactly.

Paolo: You build categories that are useful to think about an issue or a market phenomenon, then you can talk about it.

Jan: We have two questions we ask all our guests. So, this is one: what’s the worst advice you’ve heard in finance?

Paolo: I think I remember marketing pitches that unfortunately sound okay to people, and they are just outrageous. Such as once a colleague of mine was deciding on how to invest some money and then she was super happy about the type of funds that she got because they would cost only 50 base points per quarter. And she was so proud of that.

Jan: If you would recommend a book, it doesn’t need to be a finance book or academia book, which book would that be?

Paolo: That’s a tough one. That’s a tough one, but I think one book that is very inspirational and given the times we live in, I think it might actually generate incredible innovations in the social media type of thing or start-up alike. I think it’s the book of Shiller. (Title: “The new world order” by Nobel laureate Robert J Shiller)  

It’s a beautiful inspirational book about the fact that if anything, we don’t have enough markets. I think it’s fascinating to me.

That’s one of the reasons why I like financial markets and I study them. The financial market is one of the social constructs we have devised in order to share risk. 

Entrepreneurs come in with ideas, they need money, they sell you stocks, or you lend to them. At the end of the day, they share the risk of their idea with you. That’s what financial markets are really about. There are also insurance markets and so on, but financial markets are from an academic point of view, purely about sharing risk. And unfortunately, instead, we think a lot, only of them in terms of speculation or how much money you make. 

But at the end of the day, it’s a way of sharing risk, and that’s why you earn a return. Because you take risk of someone else, and the market is an amazing institution because this risk is valued constantly. And there is a price for it and one question. We live in a society with so many types of risks for which there are no markets. And the question is why? And could this market be created in a smart way? I think that’s fascinating, and that’s up for grabs. That book can be inspirational in that sense.

Jan: I’ve actually missed that totally. It’s the same Robert Shiller with the data and…

Paolo: Yes, Nobel prize winner? Absolutely.

Jan: Paulo, thank you. Thank you for sharing your knowledge. Thank you for taking the time and like talking to us explaining human capital and the academic view. I really, really appreciate it, and I know I talk for a lot of listeners

Paolo: Thank you for having me.

Jan: Pleasure. Thank you.