Entrepreneurs typically have much of their wealth tied up in their business. This concentration can generate significant returns, but also has many drawbacks.
We explain how diversification can help entrepreneurs manage investment risks, reduce swings in income, and achieve consistent returns.
We also address the practical barriers entrepreneurs and executives can face when trying to fund outside investments, outline potential ways to fund diversification, and propose five key considerations for building a diversified portfolio.
Why should business owners diversify?
Everyone faces some degree of concentration. Entrepreneurs face a more acute risk since they often also hold much of their financial wealth in one place: their business. Equally, executives are often largely paid in their company’s stock, leading them to hold far more of it than they might by choice. This focus is often the main reason entrepreneurs have achieved great wealth. But it is also a source of vulnerability.
However skillfully you manage your company, political, economic, social and/or technological developments beyond your control can disrupt your business. The tech crash of 2001 and the global financial crisis of 2008 are notable examples of such surprise events. Diversification can help mitigate these risks and provide alternate sources of return.
Furthermore, a financial portfolio can also provide an extra source of cash income. It can benefit your business too. Entrepreneurs who rely exclusively on their businesses to finance their lifestyles can bias decisions in favor of extracting cash flow from them to the detriment of pursuing long-term opportunities.
A diversified portfolio is also less likely to be damaged by setbacks in any individual security, sector, asset class, country or region. Entrepreneurs and executives can also go beyond this approach. They can use their portfolios to counteract some of the potential vulnerabilities in their core businesses.
How can business owners fund diversification?
Your choice how to fund diversification will depend on many factors, including the maturity of your business, your tax situation, and your reasons for diversifying. As an entrepreneur you may be reluctant to sell all or part of your business. Executives, on the other hand, may not be able to sell their corporate stock holdings due to company or regulatory restrictions. Some entrepreneurs use borrowing as a way to fund diversification. And if your business generates cash, drawing on it to diversify can be a good option.
What should a diversified portfolio look like?
Entrepreneurs typically have much of their wealth tied up in their businesses. This concentration of capital can generate significant returns. For example, 89 Chinese and 30 American business owners became billionaires in 2017, according to the 2018 UBS/PwC Billionaires Report.
But the same report notes that 51 people in China dropped below billionaire status in 2017. Any individual business, no matter how skillfully managed, is exposed to a wide range of risks. In a worst-case scenario, they can lead to business failure and loss of wealth. The best ways to create wealth are not necessarily the same as those to preserve it. External investments can help you avoid this fate and seize opportunities. Below are five ways to achieve effective portfolio diversification.
Entrepreneurs could buy another venture. In the ideal case this could create a second fortune – for example, some entrepreneurs in the coal industry were quick to spot the potential of shale. This may have its appeal and create new opportunities. But there are drawbacks, notably the new set of idiosyncratic risks it introduces. Buying another private business may not provide you with the liquidity you need. And the diversification benefits are limited relative to other options.
Entrepreneurs typically need more liquidity than the average investor, for example to pursue opportunistic business projects. Entrepreneurs often hold more cash than they need, even for an emergency. You may think that cash retains its value better than stocks, whose prices fluctuate daily on the market. But the value of cash doesn’t rise when equity markets fall, as highly rated bonds tend to do.
We recommend that business owners hold three to five years' worth of lifestyle expenditure in liquid assets. Beyond this amount, entrepreneurs run the risk that their portfolio won't contribute to achieving their financial goals. Splitting your portfolio into Liquidity. Longevity. Legacy.* can guard against it.
You may also find it hard to shift your money from your own business (one that you control and whose “paper value, ”if unlisted, stays constant day to day) to public stocks in businesses you don’t control and whose value fluctuates on the market. The illusion of stability may lead you to overestimate the volatility of stocks and underestimate their potential returns.
Owning a business does not mean you should avoid stocks that offer high potential returns. Entrepreneurs and executives often benefit from building a well-diversified portfolio without making sweeping changes. Entrepreneurs with more mature businesses may prefer a traditional diversified portfolio split between global equities and bonds. Younger entrepreneurs with fast-growing businesses and long investment horizons may look for higher-risk options.
Entrepreneurs may want to “tailor” their portfolio. You might look to reduce portfolio exposure to regions, countries, or sectors which your business is significantly exposed to. Tailoring for region, for example, involves assessing where your firm transacts most of its business and selecting investments less correlated with these places. It may also involve avoiding the sector your firm operates in entirely or investing more in a sector whose returns have a relatively low correlation to the performance of firms in your sector.
One of the bolder approaches is to look for businesses with the potential to disrupt your firm. We identify a number of Long-Term Investment themes (e.g. automation & robotics, health tech, genetic therapies, Fintech) that seek to take advantage of these disruptive trends.
Entrepreneurs may also consider private investments in disruptive companies. A new development in this field is co-investment platforms for “impact investments.” They focus on companies that seek not only to generate interesting risk-adjusted financial returns but to have a positive social and environmental impact.
More on how a diversified porfolio should look like can be found in our report.