Does your job make you a stock or a bond in life?

For those who are still of working age, the most valuable asset is often not a retirement portfolio or even a residence; it's one's own ability to continue to earn income through employment.

In fact, for those who are relatively young, the cumulative fruits of labor are a form of "human capital" that overwhelmingly trumps the value of everything else combined.

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The reason why this is significant is that the value of human capital is one's largest asset. So it's crucial to effectively manage the risk that it may rise and fall over time. For some people, the value of their human capital can be quite volatile, especially those in corporate and/or entrepreneurial positions, where their personal income can bounce around just like the stock of the company they work for.

By contrast, jobs in more stable industries and professions—such as being a tenured professor or working for the government—produce a consistent employment income, not unlike the ongoing payments from a bond.

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Ultimately, given both the size of the human capital asset and the fact that some careers are more bondlike while others are more stocklike, effective diversification of your entire household balance sheet might even require you to use your financial capital just to counterbalance the risks of human capital.

For instance, those with stocklike careers might own more bonds, while those with bondlike careers can afford to own more stocks. Similarly, decisions about savings should recognize that sometimes, investing in human capital can actually produce a greater return on investment than saving—even better than buying stocks in a Roth individual retirement account for the long run.

So the next time you're considering your portfolio allocation, remember to consider whether your human capital behaves more like a stock or a bond, and diversify your portfolio against it accordingly.

What human capital's worth

The concept of "human capital" draws primarily from research in lifecycle finance. The basic principle is relatively straightforward: Your future earning potential over your lifetime is a significant asset, and over time, that asset pays out its value as a series of employment paychecks.

To the extent those human capital payments support your lifestyle, they are spent; any remainder is allocated to savings and becomes financial capital to fund your future lifestyle instead.

Over time, as we go through our working years, our human capital is slowly depleted, until the point that we reach the end of our working career, transition into retirement and no longer have employment earnings. At that point—for better or for worse—we rely on the financial capital we accumulated from prior earnings to sustain our lifestyle going forward into retirement.

However, the reality is that the conversion of our human capital into consumption, and financial capital for future consumption, is not always a smooth process. Instead, the economic value of our human capital itself is volatile over time.

Its value ebbs and flows—sometimes quite dramatically—as our employment situation changes; while we can project regular cost-of-living (or perhaps additional real) increases in income over time, it's hard to clearly model bonuses, promotions, layoffs, new business ventures, etc.

And the reality is that some career paths—and their associated economic value—are much more volatile than others.

Stock or bond?

The idea of viewing one's human capital as being analogous to either a stock or a bond is a concept that Zvi Bodie, an economist and lifecycle finance researcher, has advocated (this is where I first heard the concept expressed). Retirement researcher Moshe Milevsky has actually published a book on the principle, entitled "Are You a Stock or a Bond?" as well. The concept is tied to the recognition that when looking at human capital, not all careers experience the same kind of volatility, risks and returns.

For instance, those with jobs like working for the government, or perhaps Bodie's own position as a tenured professor, might be considered "bondlike" positions. Their long-term value is stable, with little income fluctuation from year to year outside of cost-of-living inflation adjustments and an extremely low risk of being terminated.

Income generally continues in a stable manner until the individual decides he/she would like to retire and no longer work or perhaps is forced into such a transition due to a change in health.

By contrast, those climbing the corporate ladder, and many self-employed individuals and entrepreneurs launching their businesses, have a human capital value that behaves much more like a volatile stock.

It can go through abrupt changes up or down as "news" occurs (such as a big job promotion or landing a key new client or, alternatively, being demoted or getting fired).

In fact, because many of these changes in human capital may be tied to the overall economic environment—which impacts the business, whether hiring or layoffs are occurring, etc.—the reality is that your estimated human capital value in such stocklike careers may literally show a high correlation to the stock market itself. Or viewed another way, some careers may have a very high market beta.

Similarly, just as it's much more difficult than a bond to accurately value a stock—where the future cash flows and therefore their associated present value are so uncertain—so, too, it is much more difficult to accurately estimate the human capital value of a stocklike career than a bondlike career.

Financial and human capital meet

Given the difficulty of valuing human capital in the first place—especially for stocklike career paths—with both the volatility that it faces (e.g., due to the business/economic cycle, big career promotions, potential layoffs, etc.) and also the sheer uncertainty of when/whether any of those events will happen, planning for the risks of human capital should be crucial to the financial-planning process.

That applies especially to Gen Y and younger members of Gen X, who have many career years ahead. Some strategies, such as disability insurance, are fairly straightforward. But recognizing and managing the risks to human capital are about more than just effective insurance.

From the perspective of a holistic balance sheet, which incorporates both financial and human capital, effective diversification implies that if your human capital is stocklike with a high beta, the actual financial portfolio should be more lower beta, more conservative and bondlike (or perhaps even with a large outright cash allocation) to diversify and manage the aggregate volatility of the household balance sheet.

Conversely, those whose human capital is more bondlike have more of a career and human capital buffer against financial uncertainty and can afford to take more portfolio risk.

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By contrast, in practice it seems that those who have a higher level of risk tolerance tend to choose both high-beta stocklike careers and high-beta stocklike portfolios, while more conservative low-beta-oriented people often have bondlike careers and bondlike portfolios. That suggests that many or most of us are diversifying improperly, because we are failing to view our personal balance sheet holistically.

Conservative career seekers choose conservative portfolios, and those more aggressive with their careers tend to be aggressive with their portfolios; in both cases, the portfolio is just extended in the direction of the career risks rather than diversifying against them.

Similarly, the fact that stocklike careers may have far more uncertainty about the end date—when human capital may cease and the newly unemployed/retired have to rely solely on financial capital—than bondlike careers suggests that investing toward a goal like retirement in particular might be conducted differently.

Given that more volatile, equity-centric portfolios have greater "retirement date" risk—and therefore a greater risk of being misaligned with an involuntary retirement transition—it again appears crucial to ensure that human and financial capital are properly diversified and complement/counterbalance risks rather than amplifying them.

"Making effective decisions about whether to invest in human capital, how to best 'convert' it to financial capital and how much risk to take with financial capital given your risks of human capital should be key financial planning decisions."

Another important distinction of stocklike vs. bondlike careers is the relative value of making investments in human capital—i.e., spending money in ways that might advance a career, such as additional education, training, certifications, etc.

This is especially true for those who are younger and in the earlier stages of their career, where even if money spent on training and education doesn't yield an immediate return, if it increases the overall upward trajectory of income, the "return on [human capital] investment" can be significant.

In fact, modest investments in human capital for those in their early careers can create dramatically more economic value than even long-term compounding of savings in a Roth IRA, implying that a more careful analysis of where/whether to "save early" in retirement accounts is really appropriate.

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The bottom line, though, is simply this: Human capital is a key asset for those still working, and for younger workers in particular, it may represent 50 percent, 75 percent or even 95 percent-plus of their entire net worth.

As a result, making effective decisions about whether to invest in human capital, how to best "convert" it to financial capital and how much risk to take with financial capital given your risks of human capital should be key financial planning decisions.

Perhaps as a starting point, though, we should at least begin to make an attempt to look at human capital on our household balance sheet, to recognize the prospective economic value that is there, and be sure it is managed—and diversified—appropriately.

—By Michael Kitces, partner and director of research for Pinnacle Advisory Group.

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