Everyone is Asset-Based

umbrelladrink

Keep ’em comin’

What does the phrase “asset-based” mean to you? When applied to a person, it means someone with a huge pile of cash – someone who lives off his investments and doesn’t have to work. Feet up, umbrella drink on the beach, monitoring his portfolio. “Income-based”, on the other hand, means someone who has to work for a living (i.e., the rest of us). Income-based people make wages and live off the sweat of their brow, while asset-based people receive dividends and interest and rental payments and royalties and all sorts of other passive income and never break a sweat.

We all aspire to be that asset-based girl or guy on the beach, but for many of us it’s a distant and almost unreachable goal.

But in the spirit of at least tracking our current progress to the goal of never having to work again and letting our money make all of the effort, let’s see how our major asset classes stack up:

  • Cash
  • 401K / IRA or other tax-advantaged accounts
  • General investment / taxable account
  • House
  • Car
  • Clothes
  • Baseball card collection
  • Loose change in couch

How does your number look? In the millions, or is your portfolio dangerously dominated by the loose change asset class?

And lest we forget, we need to include all of our liabilities as well:

  • Credit card debt
  • Mortgage
  • Car loan
  • Student loan debt
  • Other debt

For many of us, the numbers for assets are often fairly small. In fact, as defined above, the liabilities for many people are greater than the assets. As we think about an individual’s personal balance sheet (a main goal of this site), it’s worth comparing a person to a company. A company’s balance sheet lists every asset and liability it owns, and every bit of income for that company is produced by those assets.

Companies with limited assets can’t produce much income, and those with liabilities greater than assets (“negative net worth”) are generally in trouble and often headed for bankruptcy. But many people in this same situation are not only doing OK, they’re headed for great things and may even have a beach and lots of umbrella drinks in their future.

What explains this disconnect between people and companies?

There actually isn’t one. In the list above, I’ve ignored an entire class of assets – our “human capital”. Our skills and our ability to put those to work to earn a wage. When you add those to the list, your assets expand to include everything you know and are qualified to do:

  • Intelligence
  • Work Experience
  • Education
  • Skills
  • Knowledge

But those alone don’t explain why some people earn a lot of money, and some much less. We’ve all known people of modest intelligence without a fancy pedigree who have made millions. We need to expand our list of human capital to include:

  • Work Ethic
  • Drive
  • Ambition
  • Professionalism
  • Professional Network
  • Likability / Ability to Get Along with People

Once you add all of your human capital together, and consider the value of the lifetime earnings that will be produced by it, you may already have a balance sheet worth over a million dollars. Congratulations, millionaire! But there are a number of problems with your human capital as an asset class:

  • The only way to unlock its value is to work – the harder you work, the more value it produces
  • If you don’t (or can’t…) work, your human capital becomes worthless
  • You can’t sell your human capital. It’s forever fused to you, which makes it the most illiquid investment in the world.

An additional observation of human capital is that its value is based on and increased by all of its components working together. This can lead to great synergies – if you are smart, likable, and hard working, those work together to make each one more valuable and to create even more human capital like skills and knowledge. But the reverse is also true – if you have a serious flaw, like you’re incredibly lazy or incredibly unlikable, that single weakness can sap most of the value of your entire human capital and also prevent you from acquiring any more.

Whatever the value of your human capital, it surely increases your personal balance sheet by a healthy margin. That is great news, but it also requires us to think about diversification.

Diversification of financial assets is generally a good thing. If you invest in a variety of assets that don’t move together, you’ll face less risk than if you invest in a single asset.

As an example, let’s return to our guy on the beach with the umbrella drink. What if you learned that every penny he owned was invested in a single company’s stock? His pleasant life of the beach, umbrella drinks, and not working could come to a crashing halt if that company’s fortunes fade. You’d knock the drink out of his hand and scream, “Diversify! Buy more equities, buy some bonds, buy a mix of ETF’s, buy some real estate, buy something else!”

But what if the guy on the beach turned to you, and learned that most of your net worth was tied up in a single asset that could not be sold, required years and years to extract the value, and could suffer a sharp decline or go away completely with no notice? He’d knock the cup of coffee out of your hand and cry, “You’re the one who needs to diversify! Fix your downside risk, start saving like your life depends on it, and improve your woefully unbalanced balance sheet! And while you’re at it, please get me another umbrella drink.”

Giving our beach friend some needed diversification in his liquid investments would not be too hard. Many of us have already done a good job of building a diversified portfolio in our 401K’s or other accounts. But taking his advice and fixing our own balance sheets – if they’re heavily laden with human capital – can be much trickier.

Step one is simply recognizing the problem. Every one of us is asset-based*; it’s just that many of us are less diversified (and sweatier) than we’d like. We all look forward to saving enough money so our balance sheet isn’t dominated by our human capital, but until that happens, we need to pay particular attention to protecting that asset class.

 

* We’ll still use “asset-based” as the term for our lofty goal of no longer living paycheck to paycheck. But remember that “income-based” is really just asset-based with a pretty poor balance sheet.

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