When you began your career, you likely started out with very little money or connections. Instead, you had one very valuable asset: Your human capital. In economic terms, your human capital is the capacity to work and earn a living. In your late teens and early twenties, the value of your human capital easily reaches into the millions of dollars, increasing with education and specialization. As you go through life and grow older, the value of your human capital declines until the day you can no longer, or are no longer willing, to work. At this point, your only options are to depend on the good graces of others, government support programs, or financial capital that you set aside during your lifetime to generate dividends, interest, and rents.
In essence, this means that one of your primary responsibilities in life is to convert your human capital into financial capital so you can remain independent, not be a burden on friends, family, or society, and afford the lifestyle you desire. This is accomplished by spending less than you earn and putting the surplus to work so that it generates passive income. After all, there are only two ways to increase your net worth.
How Much Financial Capital Does It Take To Replace Your Human Capital?
The question of how much financial capital it takes to replace your human capital depends upon your own investment opportunity cost.
Consider a successful heart surgeon in an average city earning $400,000 per year. Most people in this profession who are reasonable in their spending habits have a good chance of ranking among the top 1% of wealth and income in the United States. What would it take for him to collect the same income from a portfolio of high quality investments? For conservatism sake, we'll ignore that the doctor will eventually retire or die and that he could project life expectancy and aim for spending through his portfolio in the golden years of life, a scenario which would require far less financial capital. Instead, we are going to treat him as the equivalent of a financial security or asset and ask, "How much money must be invested to produce the same return?"
- If you were talking about investing in bonds yielding 5%, it would take $8,000,000 in financial capital to replace the doctor's human capital
- If you were talking about investing in stocks or investing in real estate at the historical long-term rates of 10%, it would take $4,000,000 in financial capital to replace the doctor's human capital
- If you were a very clever investor and could selectively pick up assets, such as storage units or car washes, in your hometown at very attractive prices (you'd never get those returns long-term in the stock market), earning 15% on cost, it would take just shy of $2,700,000 in financial capital to replace the doctor's human capital.
If our heart surgeon wanted to quit or retire tomorrow and still generate the same household income, swapping his paycheck for dividends, interest, and rents, whether he needs $2.7 million, $4.0 million, or $8.0 million depends entirely upon how good of an investor he is. If he retires with less than this in financial capital, he is going to be forced to experience a substantial and, perhaps, painful decrease in standard of living.
The Sooner You Amass Financial Capital, The Better
There is one major advantage to amassing financial capital earlier, rather than later, in your career. By giving your money more time to compound, you have a chance of create a situation where for a good stretch of years during the peak earnings capacity of your human capital, your money is generating as much excess surplus for reinvestment into new assets as your labor. That is, if you are saving $100,000 per year but your $1,000,000 portfolio is also generating $100,000 per year, your net worth should grow much faster because now you have $200,000 a year getting plowed back into future growth.
It is also easier to survive on a lower standard of living, making it simpler to save money, when you are younger. When you're used to living on Ramen noodles, clipping coupons, and taking advantage of sales at the grocery store from your teenage years and early twenties, depending upon how young you were when you became self-sufficient, it isn't hard to continue those practices. Once you get used to nice furniture, well-made clothes, a comfortable car, extended vacations, and good food, tightening the fiscal belt can be much more difficult. In fact, it can be emotionally traumatic for a lot of people.
The moral: Converting your human capital to financial capital is not nearly as difficult if you begin very shortly after the start of your career by generating surplus funds and putting them in every tax-advantaged shelter and vehicle to which you are permitted, such as a 401(k) or a Roth IRA. Decades and decades of compounding, tax-free or tax-deferred, can result in marvelous wealth for your household.