Entrepreneurs typically have much of their wealth tied up in their business. This concentration can generate significant returns, but also has many drawbacks.
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?
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?
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 coporate 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?
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.
More on how a diversified porfolio should look like can be found in our report.
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