The Shift from Human to Financial Capital: Why investing is so important
One of the first things we are taught about personal financial responsibility is the importance of investing for the future. This is not poor advice; after all, most of us will reach a point where we are either unable to work or would not like to work as hard. Even if you plan on working your entire life, most people would like to reach a point where they can work because they want to, not because they have to. Either way, setting aside money today and letting it grow is an intelligent way to plan for the future. When you save and invest for retirement, you are preparing for the inevitable shift of your income being generated from human capital to financial capital. The journey from relying on human capital to building and depending on financial capital is a crucial transition in anyone’s economic life. This process is not merely about saving for the sake of having a safety net; it’s about fundamentally changing the way we support our lifestyles, from earning an income through work (human capital) to generating revenue from investments (financial capital). Let’s delve deeper into this transformation with practical examples to illustrate why this shift is vital for most people.
Understanding Human vs. Financial Capital
When we use the term “capital” in finance and economics, we refer to anything that can provide its owner with financial value (i.e. income or the capacity to generate income).
Human Capital: Early in our careers, our main asset is our ability to work and earn money. Various factors, including our health, industry demand, and skill level influence this ability. For example, a software engineer in their early 30s might have a significant earning potential due to the high demand for tech skills. However, this capital is finite and tends to decrease with age.
Financial Capital: As we save and invest, we accumulate financial assets—stocks, bonds, real estate, etc. Unlike human capital, financial capital can grow through investment returns and compounding. Consider $10,000 invested in a broad stock market fund with an average annual return of 7%. In 30 years, without adding more money, this investment grows to over $76,000 and that growth represents income that can be used by the owner of that capital.
Why the Shift from Human to Financial Capital is Crucial
- 1. Sustainability: Our ability to earn an income is not guaranteed. Health issues, industry shifts, or aging can reduce our earning potential. Transitioning to financial capital means creating a sustainable source of income for the future. For instance, if you save $500 monthly in an investment account with an average 7% annual return, in 30 years, you would have approximately $611,729. This sum can significantly support your living expenses, reducing the need for a paycheck.
- Freedom: Accumulating financial capital allows us to choose how we live our lives. Whether changing careers, taking a sabbatical, or retiring early, having financial resources gives us options. Imagine you want to switch jobs in your 40s or 50s. A solid financial cushion can allow you to make this change without needing to earn a comparable salary in your new field.
- Security: Financial capital is a buffer against life’s uncertainties—economic downturns, job loss, or unexpected expenses. It offers peace of mind knowing you’re prepared for financial emergencies. For example, having six months’ worth of living expenses saved in an easily accessible account can provide significant security in case of job loss or unexpected medical expenses.
Practical Examples
Let’s put these concepts into perspective with practical examples:
Building Financial Capital Early: Jane is 25 years old and started saving $300 monthly in a retirement account with an average annual return of 7%. By the time Jane reaches 65, she will have saved over $1 million, even without increasing her monthly contribution. This early start leverages the power of compounding, emphasizing the importance of saving and investing as soon as possible. By the time Jane wants to start thinking about decreasing her reliance on human capital, she will have a lot of financial capital to help her maintain her spending needs.
Transitioning from Human to Financial Capital: John, a 40-year-old professional, decides to aggressively save and invest 20% of his annual income of $80,000. Assuming an average return of 7%, by age 65, John could accumulate over $1.7 million. This shift secures John’s retirement and provides him financial flexibility in his later working years. In this case, John might find that he has more flexibility earlier in his life to be more deliberate about how much human capital he needs to maintain as he can also rely on the significant financial capital he has built up.
The Impact of Delaying Savings: If Jane had waited until 35 to save the same amount, her retirement account would grow to only about $566,416 by age 65. This stark difference illustrates the cost of waiting and the importance of starting early, even with smaller amounts. When building financial capital, the earlier you can start the better!
Two Other benefits of investing:
- Letting compound interest pick up the bill: One of the nice things about being proactive and starting early is that you won’t have to save as much as you would have had you delay your savings and investment strategy. Why do you sometimes get a discount if you prepay a big expense? Well, it’s the same thing with paying significant future expenses such as weddings, big trips, or retirement. The earlier you start “paying yourself” for it through investing, the less you will have to set aside.
- Combating inflation: It’s a pretty good bet that whatever people are telling you they are spending today on cars, weddings, Bar Mitzvahs, and even groceries will be higher. Saving money is step #1, but money that is not invested will not be enough since the value of that money is continuously decreasing over time. Investing that money is vital step #2 where you can grow the money at a rate higher than the inflation rate. Inflation is like an invisible tax on society, so your financial capital must be invested in a way that fights it. This isn’t necessarily applicable to human capital, as Warren Buffet famously explained that you can mitigate the impact of inflation by continuous self-improvement and staying on top of your field. “Whatever abilities you have can’t be taken away from you. They can’t be inflated away. The best investment by far is anything that develops yourself, and it’s not taxed at all.”
In Conclusion
The shift from human capital to financial capital is not just a strategic financial maneuver; it’s a necessary evolution in securing your financial future. By understanding and acting upon the need to save and invest, we prepare ourselves for retirement and ensure we have the freedom to make choices and the security to face life’s uncertainties confidently.
Remember, the journey from human to financial capital is filled with opportunities to make choices that align with our long-term goals and values. It’s not merely about reaching a financial destination but creating a rich life with options and security. Embracing this shift means understanding the profound impact of our financial decisions today on our future selves. Start small if you must, but the key is to start—and to keep building towards a future where financial capital sustains and enriches your life.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
This content not reviewed by FINRA
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