Business owners need to think about diversifying their investments.
Diversification is the first rule of thumb when designing an investment portfolio. Especially in today’s volatile markets, it is well understood that investing across range of asset classes and varying risk profiles is key to wealth preservation.
Investors who have obtained their wealth through the ownership or growth of a closely held business, however, all too frequently ignore this rule. This group can be uniquely at risk as they go about their wealth planning, as they are often too heavily invested in a single asset – their own business.
Entrepreneurs devote years to building a profitable enterprise and, for many, these businesses represent the vast majority of their personal net worth. This means not only a high degree of portfolio illiquidity, but also inflexibility. With portfolio performance almost entirely predicated on that of the business, concentration risk becomes a tangible concern.
Furthermore, it is often the case that when entrepreneurs do begin to invest in other assets, they choose to invest in related businesses and industries because they feel equipped to evaluate these companies and are loath to “bet against themselves” – that is, take an opposite view to these holdings.
This only serves to exacerbate portfolio risk since similar companies frequently exhibit highly correlated performance, and the absence of hedging positions leaves their overall portfolio open to substantial loss should the markets shift out of their favor.
In order to reduce portfolio risk and preserve personal wealth, business owners should focus on building a “total wealth portfolio.” This strategy relies on integrating the business interest with more liquid, complementary investments that seek to protect against “tail events,” or unexpected market movements.
In other words, the typical private business should perform well in normal market environments. As such, the complementary investment portfolio should focus on protecting capital in recessionary markets and allow for growth in highly expansionary markets.
In order to protect against recessionary market events when the core business might struggle, investments in government bonds, gold and macro hedge funds may represent key components of the complementary portfolio.
Conversely, small cap equities, emerging market equities and high-yield bonds should help augment returns in expansionary times.
Take the entrepreneur with a cyclical business that produces high quality materials for home builders which are distributed regionally as an example.
Under a normal economic growth scenario, the business benefits from increased new home construction and remodels, all else equal, revenues and profits increase. However, in a recession, demand wanes and the business suffers. An allocation to government and high quality municipal bonds may help preserve capital as investors presumably flock to safety and bond prices rise.
On the other hand, if the economy is growing rapidly, an investment allocation to positions that are outside the housing value chain can produce higher returns with some higher volatility — such as small or mid cap equities and emerging markets which can provide exposure to other industries and demographic shifts such as energy, technology and emerging consumers. Such exposure may allow an investor to participate in this growth to a greater degree than his or her business alone would provide. In this manner, the liquid investment portfolio is complementary to the core business and helps to mitigate overall risk.
Each private business is unique, so customization is required. When selecting the appropriate vehicles for the complementary investment portfolio, business owners and their advisers need to evaluate the business’ strengths and weaknesses, geographic footprint, industry and review historical performance through different market cycles.
Once complete, a portfolio of hedging, countercyclical and opportunistic investments can be identified to preserve and grow wealth.
Particularly for those owners who plan to keep the business in the family or provide for future generations from the wealth created, a total wealth portfolio strategy is critical. Ensuring that risk is not concentrated in a single asset or sector will help maximize the assets that can be part of a legacy for the benefit of heirs and help business interests remain intact for generations to come.
Entrepreneurs are natural risk takers. It’s what makes them successful. But after working so hard to build a business, it’s imperative to preserve the wealth that comes with that success.
Ian Kerrigan is an Investment Specialist with J.P. Morgan Private Bank in Seattle