We tend to think of capital in terms of only money. Cash. But the true definition of wealth goes far beyond that. On the one hand there’s social capital - the value of social connections, relationships, and networks - and it does figure into the big picture.
Perhaps even more important is human capital. If you’ve never heard of it before, or given it much thought, it’s time to right that wrong. Human capital is the earning potential of your labour over the course of your career(s). It is and should be part of the equation when thinking about and planning your wealth. Human capital is highest when your financial capital (the traditional notion of how much money you have) is at its lowest...on the very first day of your working life. In this scenario, you have your entire working existence stretched out before you. 40-45 years’ worth, and it registers in the millions of (potential) dollars. Your actual financial capital is probably very small, if not negative (student loan debt).
Over time, this hierarchy reverses itself. Each day you work, you gain a little financial capital (earn some money), and you lose a little human capital (one less day you will be able to work and earn a living), until eventually your human capital is essentially zero in your old age. The circle of life.
Human capital is not created equal. Your individual education, background, previous work history, geographical location, demand for your particular skill set, and on and on, determine how much money you can potentially make over your lifetime. Some of it is remarkably unfair - men still make more on average than women - even in the same industry with the same education - over their career.
The trick to a secure financial future is to convert human capital into financial capital as soon as you can. Earn. The sooner you start, and the younger you are, the better.
Increasing Your Human Capital
There are many ways you can increase your human capital, or earning potential. The system works by exchanging your time, effort, expertise, and labour for some sort of financial remuneration. The quickest and easiest way to see the relationship is to calculate your hourly rate (easy if you’re currently working by the hour) and multiply that by the number of hours you are going to work in a given day, week, month, or year. Viola! Human capital to financial capital...you can see your earning potential in terms of actually earnings.
In this simple example, you have two ways to increase your human capital:
1. Work more hours
2. Charge/Earn more per hour worked
Obviously, that might be easier said than done. But by either increasing the number of hours worked (switching from freelance to part-time, or part-time to full-time) or the hourly rate (asking for a raise, getting a promotion), you’ll immediately increase your human capital, which can then be converted to increased financial capital. Oversimplified? Maybe...but that’s the system in a nutshell.
Increasing Your “Hourly” Rate
Even if you are a salaried employee, you can still think in terms of hours worked and hourly rate. You want the number of hours to ideally stay the same (or even decrease), while slowly earning more per hour worked. The good news is that it tends to happen with no additional effort on your part. The longer you stay with a position or company, the more you make, usually in the form of annual raises and movement up the corporate ladder.
Beyond that, you can actively work to increase your human capital by increasing or improving the elements that directly affect it.
- Improve your qualifications with additional education (Masters, Ph.D, certifications, etc.)
- Increase your skill set (new languages, new computer skills, other skills related to your particular industry)
- Move to a stronger economy (where you live has a direct influence on your earning potential). Quite simply, you’ll make more money in some countries/cities than others.
- Recession-proof yourself by finding a job or industry that better survives them.
Converting Human Capital to Financial Capital
The system at its most basic - you work (human capital) for pay (financial capital). Once you are earning money, you’re essentially converting one to the other. Easy.
You need to convert fast and furious while you’re young, giving yourself as much time as possible to convert and then increase your financial capital over your working decades.
Increasing Financial Capital
There are a few things you should be doing in order to increase your financial capital:
- Lower your cost of living (move to a cheaper location, or cheaper housing; spend less on luxury items when you’re young)
- EARN as much as you can. If that means working longer hours than you’d prefer (at least initially), then so be it. Always be working to increase your earning potential via the methods mentioned above.
- SAVE the money coming in. As much as you can. No, it doesn’t mean never enjoying yourself or going out or taking a vacation, but it does mean you should be very selective about those things. Set up an automatic amount to come out of your paycheck and into a savings account. 10% should be the minimum, and increase the amount as soon as you can.
- INVEST your saved income. Whether you look at stocks, bonds, real estate, or whatever (please do your homework, and ideally speak to a professional financial advisor), you want to start immediately. Compound interest on those investments can work wonders if given enough time. Contribute to your 401(K), RRSP, or equivalent. Check out Are You a Stock or a Bond? by Moshe Milevsky, an excellent book that looks at the relationship between human, social, and financial capital and their effect on your investment choices. There are some great tips and advice for choosing the right path.
- PROTECT your investments (and yourself) as much as you can. The younger you are, the more risk you can take when it comes to investing...high risk can yield high reward, but if the worst happens (you lose most or all of it), you have time to recover. As you get older - and your human capital well begins to dry - you shouldn’t be taking as many risks. Plan for the unthinkable, too. Are you covered if you lose your job? What would happen to your family if you suddenly died? Insurance (life or otherwise) is a good idea. And avoid investing both your human and financial capital in the company you work for...investing in or getting bonuses that involve stock in your company may prove fruitful, but if the company folds or goes bankrupt, you’ve lost your job (human capital) and wealth (financial capital). That’s a brutal double whammy. Diversify to protect yourself.
Your total wealth is the sum of your human and financial capital. Know that going in, work to improve one, and the other gets dragged along with it.
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