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Your human capital, not investment returns, is your biggest wealth creator

Posted on 06 Feb 2022
Author: Sayan Sircar

Tags: Portfolio Construction

10 mins read
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Do not chase returns. Invest more instead. To do that, focus on increasing your income by focusing on human capital.

Your human capital, not investment returns, is your biggest wealth creator

The process of investing

The purpose of investing is to have money ready to be spent for a particular purpose, on the date needed, for the intended amount. For example, when your child was three years old, you started investing, using a plan like this, to ensure that sufficient money is there for paying for their college education the day the admission is due to happen. The entire fee and other expenses is available for spending as per an investing process followed for the last fifteen years.

Compounding is the process that gets us to that goal, and we implement the compounding process via goal-based investing. This is the reason growing wealth is not a goal, but having a target lifestyle in retirement, sending children to the desired college, buying a particular house or car, or regular vacations are goals. To do this, we need to understand how compounding helps us on the journey:

Compounding formula

This formula is an example of an exponential curve where the current period growth happens on the entire corpus from the previous period. A good example is simple vs compound interest:

simple interest: 100 > 110 > 120 > 130 > 140 etc
compound interest: 100 > 110 > 121 > 133 > 146 etc

This interest-upon-interest feature is the reason compounding grows so fast and is the premise of this quote:

My life has been a product of compound interest” - Warren Buffett.

There are three takeaways from the compounding equation:

You need money to make money: how much you can invest every month will impact the principal figure. If you earn ten lakhs and save one lakh vs earn thirteen lakhs and save four lakhs, that is an automatic way to get four times higher final corpus, with everything else remaining the same
You need to be invested for an extended period: A portfolio growing at 10% on average doubles in value every seven years. This means that you need to have a proper plan for investments and do not pull out money randomly
You cannot predict the return you will get: you cannot predict the future and, apart from luck, are a taker of returns given by the market. However, this should not be interpreted as “returns do not matter”. Returns are unpredictable and cannot be relied upon. Instead, the probability of reaching the target corpus is maximised by managing risk.

We cover compounding in more detail in these posts:

We can control how much we can invest every month by reducing our expenses or, even better, by increasing our income. How much we invest monthly and what we withdraw has a substantial impact on the final corpus. For example, investing too little is a common mistake. This issue happens when investors have not calculated the target corpus for their goals. Due to this issue, investors believe that a small SIP is sufficient for reaching their goals. As a result, they keep the rest of their investments in the bank, which does not beat inflation.

A SIP should also be increased every year as salary/income increases as part of the yearly goal review process. Assuming a 30 year investment period and average 11% returns,

Compounding example

₹ 1 lakh/year fixed SIP yearly leads to a ₹ 2.21 crore corpus
₹ 1 lakh/year SIP increasing at 10% yearly leads to a ₹ 6.04 crore corpus
₹ 1 lakh/year SIP increasing at 15% yearly leads to a ₹ 12.02 crore corpus

Investors can plan for their goals and figure out how much they need to invest using this Excel template. This entire discussion, specifically the point of you needing money to make money, brings us to the point of human capital and what is it’s role in ensuring that we reach our investment goals.

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What is Human Capital?

Human capital

Human capital is an estimate of the future earning potential of an investor, either from salary, profession or business. As age increases, human capital will reduce; however, the investments made by the investor create a portfolio i.e. financial capital that meets all financial goals.

Human capital is defined as:

Human capital = Present value of discounted earnings of an individual over their lifetime

and is the total effect of intelligence, education, skills, knowledge, training, health, performance, attitude and work ethics.

Human capital increases when:

you actively spend time in training and courses for increasing your skills and knowledge that create new career opportunities
keep yourself healthy so that preventable health issues do not impact your career and hence earnings potential
actively showcase your skills, knowledge and abilities to prospective recruiters, customers or clients via networking

Human capital decreases when:

you do not stay updated with the latest happenings in your field, whether that is a salaried job or as a profession in fields like Accountancy, Law or Medicine
you are not working for an extended period due to either a career break or health issues
your focus is on activities that rely more on luck than on process and skill as far as growing your financial capital is concerned. Some typical examples are trading, analysis of individual stocks and monitoring portfolios hourly or daily

An average investor who lacks the time or skills to track markets or pick funds/stocks should aim for

investing in low-cost passive investments: Which funds should I invest in?
understand goal-based investing as a process and follow it
devote their time and energy to increasing their income

Human capital and the best usage of time

Growing wealth depends on income and investments and is one of the axioms of personal finance. There is an intrinsic limit to the amount of time you can spend per day or week in your primary profession. If you know your hourly wage, and you should like this, you should also be aware that you cannot scale the denominator i.e. hours spent working every day indefinitely. This leads to the concept of increasing human capital, where you are enhancing your skills and knowledge to increase your income - both active income from your profession and passive income from other sources.

Greatest returns come from human capital

For example, if you are investing in stocks directly, either trading and investing, you are spending a good amount of time in that activity trying to get higher returns than the index. You should consider if it will be prudent to divert that time to your profession instead to increase your income to get more capital for investing and leaving investing to mutual funds. Here we see two investors getting the same average return from their investments over 30 years. One of them gets salary hikes of 10% a year while the other gets 20% hikes. Over time, their portfolios diverge, and the second portfolio ends at a value that is 4 times higher than the first.

What should be the right thing to do?

Know that salary hikes are permanent

If two people join the same company and one gets a 10% salary hike in one year and the other does not, then assuming that the rest of their careers and expenses and investment returns over time are same then the one with the hike will come out ahead. Such hikes come by increasing human capital.

We defined earlier that human capital is the totality of intelligence, education, skills, knowledge, training, health, performance, attitude and work ethics. If you have an extra say, 10 hours a month and have the option of deciding what to do with it, then spend that time in:

online courses that teach you new career-related skills
get training to improve your employability both for current and future employers
keep your knowledge updated in rapidly changing fields
give and receive mentorship to get to the next stage of your career

You should prioritise these steps over anything that improves investments returns which is the only part of the compounding equation that is not under our control. Analysing stocks, funds and IPOs or trading in shares and derivatives (FnO) can be exciting but only as a pastime. These activities should be recognised as a time sink at best and detrimental to your future financial goals at worst. Ideally, spend as little time as possible in:

trying to analyse and find the best companies, mutual funds, IPOs and other investment options
focusing on the noise related to investments and the stock market from TV, newspaper, and social media in every form
tracking markets and your portfolio daily. A review every six months or one year is sufficient
attempting to beat the market or improving portfolio returns. Both of these depend a lot on luck than skill

Keep in mind that knowledge is power

We have discussed the process of goal-based investing extensively in this blog. These three articles will get you started on the process:

Along with this, you need to understand the concepts of

evaluating different investment alternatives to know their suitability for you
going through reviews of various investments products (like here) to understand why, if at all, you should invest in them
understanding your risk profile
how to manage portfolio risk by asset allocation, review and rebalancing

Identify what you can and cannot control

Ultimately you need to understand which of the various factors that affect your investments are under your control and which are not vs. which of these are important and which are not.

Investor behaviour: control what is possible

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Worked out case studies for goal-based investing

Case study: how can this middle aged investor with two children plan for retirement and children's goals?

This article shows how a single-income middle aged couple with two small children reach their retirement and children’s goals.
Case study: can this double income single kid family reach FIRE at 50?

This article shows how a double-income couple with a 2-year old reach their FIRE dream at the age of 50.
Case study: how a family in their mid-30s with a newborn kid can FIRE and invest in real estate?

This article shows how a double-income couple with a newborn child can invest for their future goals of FIRE and real-estate investment.
Case study: how this double income recently married family can perform DIY goal-based investment planning

This article shows how a young just-married couple can invest for future goals using the Arthgyaan goal-based investing tool.
Case Study: How should couples in their 40s with a new baby plan their financial future?

Did you welcome a bundle of joy in your 40s? This article will discuss ways of planning the child’s (and your’s financial future)
Case study: how this double income single kid family can perform DIY goal-based investment planning

This article shows how a very typical salaried couple with one child can invest for future goals using the Arthgyaan goal-based investing tool.

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Topics you will like:

Asset Allocation (20) Basics (8) Behaviour (10) Budgeting (11) Calculator (17) Case Study (6) Children (12) Choosing Investments (38) FAQ (6) FIRE (13) Gold (11) Health Insurance (4) House Purchase (17) Insurance (15) International Investing (10) Life Stages (2) Loans (9) Market Movements (13) Mutual Funds (29) NPS (6) NRI (13) News (9) Pension (8) Portfolio Construction (46) Portfolio Review (27) Reader Questions (6) Real Estate (6) Retirement (36) Review (12) Risk (6) Safe Withdrawal Rate (5) Set Goals (27) Step by step (14) Tax (37)

Next steps:

1. Email me with any questions.

2. Use our goal-based investing template to prepare a financial plan for yourself
OR
use this quick and fast online calculator to find out the SIP amount and asset allocation for your goals.

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