One of the greatest mistakes many business owners make is overestimating their personal levels of diversification while underestimating their risk exposures.
By personality type, entrepreneurs tend toward risk, but they may not realize that investing all of their extra net cash flow back into their business can be a significant risk in itself if not managed properly.
FALSE SECURITY
The financial stake in your business is essentially an equity holding, much like publicly traded common stock but without the benefit of liquidity and the diversification that can come with owning multiple common stocks. Business owners may think of their ownership interests as a fairly stable investment because every year they may be drawing the equivalent of a salary from them. The present and future of a business, however, is like any other investment: It offers a certain rate of investment in the future, made up of the income return above the opportunity cost of your labor and any liquidation event such as a sale of the company. These returns may be unstable, especially if the business you own operates differently as the business cycle changes. Additionally, the illiquidity of the investment adds another layer to this cyclical risk. As such, when considering your stake in your business, it may be best to include it in the stock side of any traditional asset allocation between stocks and bonds.
DIVERSIFICATION AND ACCUMULATION
When you are able to view your ownership interest as an equitylike investment with its attributable returns and risks, it quickly becomes apparent why diversification of personal wealth becomes important. Eventually, business owners become more concerned with wealth preservation as opposed to wealth accumulation. The focus then becomes a portfolio that includes liquid, diversifying investments.
If you are in your mid-fifties, for example, you could have 50 percent to 80 percent of your assets in equities, but if you have nearly all of your net worth (beyond your place of residence) in your business, you may be taking on more risk than someone in their mid-fifties with a similar need for income who is not a business owner. From a wealth-preservation perspective, a superior portfolio can be constructed by using assets that have a low or even negative correlation with your business. This may be achieved by utilizing various types of bonds, common stocks or non-traditional assets.
BUSINESS OWNER INVESTMENT STRATEGY
A solid investment strategy for a business owner should contain three components: Valuing your business as an asset to incorporate it with the rest of your investments, owning separate conservative and liquid assets, and having a roadmap and timeline for your exit/transition strategy. Taking all of these components into account and aligning them with your future goals and cash flow needs can lead to financial success and independence. If you have not thought about how your company impacts your other investments, now may be the time to reevaluate the risks you are taking.