Risk and Return

In Chapter 10 we discussed how employees, unlike investors, cannot easily diversify their personal human capital investments. Therefore, no discussion of developing and investing human capital would be complete without dealing with risk. Every capital investment has a unique risk-return component, and human capital is no different.

In free and efficient markets an investment’s level of risk is correlated positively with its expected return. Consider an investment in U.S. Treasury bills, debt securities with maturities of 90 days or less. Because the full faith and credit of the U.S. government stands behind T-bills, they are essentially riskless. Financial economists in fact use the T-bill rate as a proxy for the risk-free rate in calculating the expected returns from other types of investments.

Low-risk investments generally produce low returns. The only way to obtain a higher level of return is to take greater risks with one’s capital. Financial scholars have described the relationship between risk and return by referring to the capital market line, a theoretical line that originates with the risk-free rate and intersects the expected returns of different classes of investments. Figure 13-1 indicates where familiar investment securities generally fall along the capital market line. Note the position of “Investment X.” This “inefficient” investment provides its owner with the worst of both worlds: high risk and low return. A wise investor recognizes and avoids these situations, insisting that risk be commensurate with the level of return.

Figure 13-1: The Risk Reward Relationship

There is a clear relationship between the risks people take with their financial capital and the return that capital may generate. That relationship holds for human capital investments when labor markets are free and efficient. One obvious investment a person makes is in education, forgoing current earnings and investing in credentials and new skills in the hope of getting greater returns later. Many academic studies have quantified this with estimates of increases in annual earnings of 5 percent or more for each year of college. Our work, however, has shown that the returns to education vary considerably by job and employer.

Risk and return for human capital go far beyond education and training. Consider the situation faced by commission-based salespeople. Because returns on their labor are entirely subject to their individual sales production, they cannot forecast the size of their paychecks from month to month or year to year. Returns are highly uncertain, that is, highly risky. If they have more than a few bad quarters, they are likely to be dismissed. Being a commission-based salesperson is a risky proposition, but the potential returns are very high. In some companies commission salespeople are the top earners, earning more than the senior executives do.

In contrast, unionized employees manage risk differently. They work under a legal contract that guarantees a certain wage, specific hours, safety conditions, benefits, and in some instances protection from layoffs. The unions to which they pay dues also may provide unemployment subsidies and supplemental retirement income. Overall, the situation for unionized employees is much less risky than that for commission salespeople, but some union personnel pay for that security with lower returns on their labor.

What is the risk-return profile of your human capital investment? Is the return you’re getting commensurate with the level of risk? In other words, is your investment “efficient?”

General Versus Firm-Specific Capital

Every working day presents opportunities for building a person’s human capital—capital that will pay dividends in the future. Training seminars, negotiating sessions with third parties, challenging new assignments—each of these things and dozens of others add to one’s storehouse of technical skills and know-how, at least in theory. Some, however, contribute to the riskiness of a person’s capital while others reduce the risk. Consider these two examples:

• Helen is a control-room operator at a nuclear power plant. She is well paid and is viewed within the company as a member of a highly trained elite. The training required for her position was long and intensive, conducted in both formal and on-the-job settings. She is one of only 15 such employees in her company.

• Patrick manages a manufacturing plant with 180 employees. He too is well paid and highly regarded by corporate management. His plant operates production lines that produce three different types of automotive steering mechanisms. Patrick worked his way up to his current position through a string of progressive job moves within his current company and in two others. In addition, he is halfway through the MBA curriculum offered by a local university, which he attends two nights each week.

Helen has developed a very high degree of firm-specific capital. What she knows and what she does are very critical to her current job and to her company, and it pays her accordingly. Opportunities to employ that know-how elsewhere, however, are limited. By Helen’s own estimate there are very few positions as a control-room operator in the entire country. Even if she took a position at another plant, Helen would have to receive additional training and be certified by a government agency on that reactor. Also, her know-how is not easily transferable to another industry.

Patrick, in contrast, has developed much more general human capital. He knows how to manage people and deal with budgeting, planning, and customer relations, skills that can be used in any business. He has spent a lot of time learning the specifics of manufacturing steering components, but much of that learning can be transferred to most other types of manufacturing.

Helen and Patrick have developed their human capital with major differences in risk. Helen’s human capital appears to have a high inherent level of risk. If her job were eliminated tomorrow, there would be little or no demand elsewhere for her know-how. She might have to endure a long period of waiting and recertification before her capital would begin to provide a similar return. However, the uniqueness of her capital may be such that her company could not get along without her.

Patrick, in contrast to Helen, has developed substantial general skills for which many companies—even outside his current industry—will gladly pay. The many calls he receives from executive recruiters make this clear. Thus, if something adverse were to happen to his company or industry, he would be well prepared to shift his human capital elsewhere.

The downside risk of being a generalist like Patrick is twofold: Highly technical positions are closed off, and generalists are often replaceable by other generalists. However, the downside risk is offset to a large extent by the upside opportunities.

Where do you stand on the issue of specific versus general human capital? Everyone has some of both. Which is your stronger side, and which are you investing more in growing? Are your skills so specialized that mobility is difficult or impossible? Are specialized skills what your company rewards? (If you have a high proportion of firm-specific human capital, typically you should be demanding a greater return for investing in those skills, which have value only to your current employer.) If you are a generalist, does your employer perceive you as being easily replaceable? Does your company reward general human capital? Is the return you are earning on your human capital commensurate with the risk?

Is This Where It’s Heading?

More than half a century ago, Nicholas Butler (1862–1947), a former president of Columbia University, offered a wry view of generalists and specialists. The world, he told his listeners, had become one in which specialists spend their time learning more and more about less and less. Generalists, in contrast, are learning less and less about more and more. “Before long,” Butler quipped, “half of the population will know almost everything about almost nothing, and the other half will know next to nothing about everything.”