Non-Marketable Assets and Capital Market Equilibrium – Redux

[This is another of a series of editorials by Executive Editor Andrew Karolyi at the Review of Financial Studies featuring recently published papers at the journal. This editorial features “Human Capital as an Asset Class Implications from a General Equilibrium Model” by Vanderbilt University’s Miguel Palacios. This paper is from Issue 28 (4) for April 2015. It was selected as an Editor’s Choice article on Oxford University Press web site for RFS.]

As young graduate students at the University of Chicago in the 1980s, I and my colleagues were strongly encouraged (compelled!) in Professor Eugene Fama’s asset-pricing course to read an article by David Mayers published in 1972. It was Dave’s thesis paper and was one of the contributions to the celebrated edited volume by Michael Jensen (Studies in the Theory of Capital Markets) that inspired a lot of modern finance. This excellent paper extended the classic CAPM model of capital market equilibrium of Sharpe (1964), Lintner (1965), Black (1972), and others to include nonmarketable assets such as human capital. The model adapted the expected return-risk relationship to redefine the benchmark model to include all marketable assets as well as the total payoff (income) on all non-marketable assets. And, of course, covariance risks – yes, now two – were accordingly redefined. The concept seemed very intuitive, but yet never really seemed to gain much traction in the empirical testing that followed. I was fortunate to be hired as a young assistant professor at Ohio State where Dave served as a senior colleague and I asked him once why the idea never gained more attention. The turning point, he argued, may have been a seminal 1977 study by Fama and Bill Schwert that collected income data from the U.S. Department of Commerce and that tested for – and comfortably rejected – the need for this extension for the cross-section of U.S. returns.

A number of years later, it seems Dave Mayers’ early work inspired another young graduate student at UC Berkeley, Miguel Palacios, who was intrigued enough (unlike yours truly!) to pursue the question further. And thank goodness for that–the fruits of his labor is celebrated in the form of a very nice contribution to the Review in its April 2015 issue. In the paper, Miguel derives the value and risk of aggregate human capital in a stochastic equilibrium model with Duffie-Epstein preferences (the continuous-time analogue of the more familiar Epstein-Zin preferences). Besides human capital’s value and risk, out of this comes a three-factor model including the market portfolio, the share of capital (relative to labor) and investment in human capital. The amazing statistic is that, upon calibration, the model estimates human capital to constitute a whopping 93% of aggregate wealth, well above what most previous studies have estimated. A second major finding is that human capital is a relatively safe investment, with attributes more like a bond than a stock. There are nuances about this last finding with respect to the horizon over which one judges it.

entrepreneur-1419389_640-pixabayWhen I called on Miguel to point out the most salient facts that readers should take away from his paper, he offered generously that his is not the first paper to assert the importance of human capital as a fraction of total wealth and that the portfolio choice literature has traditionally assumed human capital is safe. Not even the technique of calibrating a production-based asset-pricing model with an implicit valuation for human capital is novel.  What he argues is new is its focus on human capital in a comprehensive theoretical framework where the main economic factors determining its size and risk are part of the analysis. He sees the potential implications going beyond the identification of a three-factor model or of serving up the potential use of investment in education as a conditional variable in its testing. Focusing attention on the characteristics of the asset is the story of the hour.

I say we should welcome the return of human capital, if it ever left. It fits well with our discipline’s penchant for evaluating alternative multi-factor specifications for pricing, so welcome to the competition, human capital, and good luck to you. To the extent that it reflects back the cumulative investment in education we make (20 years before joining the workforce, 50 years of work after that, a substantial fraction of the population devoted to teaching, etc.), its magnitude may very well be as large as that in physical capital, so we should not ignore it. And, as big as human capital may be in countries like the U.S., I wonder about its potential importance in countries like China, India, Brazil, and other emerging markets around the world.

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