What is your most valuable asset? Your business? Your house? Your investment portfolio? The pile of gold buried in your backyard? What would you guess?
If you guessed anything tangible, you guessed wrong. Your most valuable asset is what economists call your human capital. This is the sum total of the skills knowledge and wisdom you possess which you then trade with your employer or your customers for money.
When you are young, human capital represents the lion share of your total wealth. As you age and begin to accumulate other assets, human capital becomes a smaller proportion but still is your largest asset.
If that is so, and economists tell us it is, then your biggest risk is not being sued if someone slips and falls in your driveway, a protracted bear market or the cost of long-term healthcare. Your biggest risk is disability or obsolescence. Both have the potential to seriously disrupt your income.
Think of it. As long as my income stream keeps flowing, I can get through almost everything else. Suppose someone does slip and fall in my driveway. They sue me and the court awards them millions of dollars. I may file for bankruptcy but the court will allow me to keep enough of my income to keep a roof over my head and feed and clothe my family.
Imagine we experience a depression which takes thirty years for stock prices to recover from. As long as I don’t lose my job and I can still work, I can still eat. Imagine I work in a family business that continues to pay me long after I have become old and feeble. Long term healthcare is not a problem.
I am not saying life would be champagne and caviar. I am just saying it would be better than the alternative. A steady income solves many problems. Loss of one can wreak havoc.
We have two choices when it comes to risk. We can either hedge it or insure it. Insuring a risk is almost always more costly than hedging it because the intermediaries, namely insurance companies, have to make a profit over and above the cost of the hedge.
We can insure the risk of disability by purchasing disability insurance. Some employers offer disability insurance as an employee benefit. Disability policies can be either short term or long term.
Short term disability policies pay you a percentage of your salary if you are temporarily unable to work because of injury or illness. A typical policy will cost you anywhere from 50% to 65% of your pay for anywhere from two weeks to two years, depending on the policy you purchase. A period of 13 to 26 weeks is more common and then long-term disability kicks in if you have it.
Long-term disability replaces income for a much longer period of time. Policies usually limit benefits to five years or age 65, whichever comes first.
Of course, being the optimists that we are, no one likes to think about what happens if disaster strikes. But the question asked by a Family CFO most often has to be, “What if?”
Data from the American Council of Life Insurers tells us one in seven will experience a disability lasting more than five years. The odds increase to one in five for those of us between the ages of 35 and 65.28 It turns out the leading cause of disabilities is not freak accidents, as many people think, but instead is caused by devastating illnesses such as cancer or heart disease. The long-term loss of income is so disruptive that 46% of home foreclosures are due to medical disability.
You cannot insure against obsolescence but you can hedge against the risk. How? By making constant upgrades to the software between your ears. The best hedge against being replaced by a 23 year old whiz kid is lifelong learning.
Those who do not read are no better off than those who cannot. ~Proverb
Lifelong learning need not be formal to be effective. I had the pleasure of interviewing Dr. Benoit Mandlebrot for my radio show several years ago. Dr. Mandlebrot is a mathematician who is best known as the father of fractal geometry. Fractal geometry is what makes the stunning reality of modern day computer animation possible.
Dr. Mandlebrot’s accomplishments are unique in that he has been awarded major prizes not just in mathematics but also in physics, medicine, science and technology. His concepts have also been applied to economics, earth sciences and linguistics.
Dr. Mandlebrot credits his ability to think outside the traditional confines of a single branch of science to his unconventional education. He said in one interview, “To tell the truth, and not to sound pretentious, but circumstances prevented me from acquiring a real college or university education in the traditional sense, so I am primarily self taught.”
Disability and obsolescence can both be hedged by building a portfolio which produces enough passive income to pay all the bills, as described in chapter 14. When passive income equals or exceeds day-to-day living expenses, work is no longer a necessity, it is a choice.
For my husband Jim and I, we use a combination of passive income and disability insurance to hedge our risk. Because I am the public face of our company, if I were to become disabled, our business would be seriously impacted. But we still have employees and bills to pay.
We have a disability policy on me which specifically covers the overhead of the business in the event I am disabled. We rely on the passive income from our investments to replace our income from the business.
Americans’ increasing longevity can be an economic blessing or a curse. Provided we remain healthy, increased longevity increases our human capital. If our mental and physical health declines as we age, our human capital is diminished.
Thus, there is one other thing you can do to increase your odds of financial success and it has nothing to do with saving or investing. Take care of your body and your mind. Quit smoking, eat right and exercise. These are as much a part of achieving lasting financial success as a sound investment strategy.
The preceding is an excerpt from Kim Snider’s yet-to-be published – but getting closer book, “The Family CFO’s Guide to Financial Success.” This book should be available in bookstores everywhere (don’t you agree?), but isn’t – until Kim stops procrastinating on the second draft!