Warren Buffett commented on the likelihood of future inflation during the most recent Berkshire Hathaway annual shareholder meeting and in his most recent shareholder letter.
Buffett’s advice for protecting against inflation involves two options:
- Increase your earning power.
- Invest in great businesses.
For most of us, the first option is easier and more realistic than the second since our labor income is largely within our control—driven by decisions about education, career, leisure time, etc.
Labor income or earning power is a fundamental feature of life-cycle investing. In the world of life-cycle finance, the value of one’s future earnings is referred to as human capital.
For most people, human capital is likely their largest and most important asset.
Consider the example of a 40 year old person who plans to work for an annual salary of $75,000 for the next 25 years. Using a discount rate of 3.5%, the value of this person’s human capital is $1,236,113.
This is a big number and a highly simplified example.
The reality is that this person’s wage may increase over time. Also, the discount rate used to calculate the present value of future earnings will most certainly change over time, and the rate will be correlated to expectations about future rates of inflation.
It is important to remember that a higher discount rate (the “denominator” in the human capital calculation) will result in a smaller human capital valuation. As a result, an essential financial goal is to keep one’s earning power or annual salary growing at the rate of inflation—ideally in excess of the rate of inflation.
Higher levels of earnings = a higher human capital valuation.
So why is human capital one of the best inflation hedges? Human capital is likely your largest single asset and unlike so many other assets or investments, it is directly under your control.
