It’s a given that business owners have to be comfortable taking on risk. However, they often overlook the biggest risk to their personal financial well-being: most of their capital is tied up in a closely held private security that is illiquid and involves multiple risks that they do not control. That, in a nutshell, is the rationale for diversifying risk by building an investment portfolio of public companies.
Replicating your success in the world of public investing involves trusting the business acumen and discipline you have developed so carefully over the course of your career. The strategies you use to build a profitable business include many of the approaches used by people who successfully invest in public companies.
In your own business, logic and reason prevail and risks are carefully calculated. You make decisions with confidence based on a thorough knowledge of your sector: the competition, the economics, the trends, the potential threats to the status quo, the changing landscape. You take measures to avoid capital loss, examining the downside to determine how much money is on the line and making certain that you can afford the fallout if things don’t go as planned. You focus your attention on operating one or two businesses and invest for the long term – decades, even generations. Naturally, you expect that bad years will intermingle with good years throughout the growth of your business.
Keeping the same mindset when investing in public companies will go a long way toward ensuring a successful investing experience. Because the whole point is to diversify some of your capital out of your geographical area and industry sector, you will be entering a new world where you may not have the expertise and knowledge that guides decision-making in your own sphere. It would be counterproductive to try to master a new field or, worse, to make decisions on the fly. Rather, continue to focus your efforts on what you know best – your business – and draw on the experience and knowledge of investment professionals to help you make profitable investment decisions to build your own personal pension plan.
Low-cost, time-efficient investing that provides good returns
A cost-effective and time-efficient way of drawing on the knowledge of everyone investing in the markets is to take a market-based (index fund) approach to building a portfolio. This method reduces risk because it avoids three wealth-destroying mistakes that investors consistently make:
- Betting on outperforming the market (e.g., trying to time the market or find a bargain before the pack recognizes it);
- Failing to broadly diversify holdings; and
- Racking up investment costs and tax repercussions through management fees and excessive trading.
Download a discussion paper titled Costs Matter by Assante Wealth Management.
Historically, the stock market has provided returns of 9% per year, but the mistakes listed above have eroded actual returns realized by investors.[i] To counter the problem of eroded returns, index funds were designed to deliver an average return, rather than taking the riskier “active” approach of targeting outperformance. Index funds “passively” follow or mirror the movements of the market, pooling money from individual investors and buying fractional amounts of each of the securities the index tracks. Costs are low because the expensive research and analysis required by active managers is not needed, so the funds can be managed largely by computers.
Index funds are based on two principles: the markets work, and prices are fair. In the very competitive public capital markets, new information is quickly reflected in prices through the millions of voluntary trades made every day.
A properly structured investment portfolio reduces the overall risk you are carrying.
A market-based investment portfolio can be structured to achieve a very reasonable rate of return. We’re accustomed to thinking of a “basket” of securities containing a variety of stocks with different expected returns (different risk profiles): holding a basket of index funds tailored to your risk preference is an extension of the same idea. There are plain vanilla funds, consisting mostly of larger companies, which track the market capitalization–weighted index (in which companies are weighted according to the market value of their outstanding shares). Sophisticated fund providers also structure index funds that can be used to target higher expected returns by tilting the risk exposure to different factors that historically have been associated with performance above the general index. These factors (or dimensions) are as follows:
- Company size: Portfolios comprising smaller companies tend to have higher expected returns.
- Relative price: Price comparisons can be based on book value or earnings, for example. The lower the price you paid, the higher the expected return.
- Company profitability: Higher profitability is associated with higher expected returns.
When building your investment portfolio, also consider exposure to international and emerging markets, which not only reduces risk but also increases expected returns. Including real estate and bonds in a portfolio will help to smooth returns.
General guidelines for structuring your portfolio
- Pay attention to asset allocation. Because you are spending your risk capital in your business, a market-based portfolio should be balanced (i.e., it should also include low-risk, fixed-income securities).
- Keep your investing costs low (i.e., reduce the number of trades you make).
- Build your investment portfolio in the overall context of your business and family financial plan and seek professional advice throughout this process.
- Make sure your portfolio is tax-efficient, again drawing on professional advice. Tax efficiency will become increasingly important as new legislation for small business owners takes effect.
As with your business, think long term and be realistic: expect periods of favourable returns to be interspersed with middling returns or even occasional bear markets (periods of falling stock prices). Find trustworthy advisors to help you map out a long-term strategy and then stick with the plan.
A properly structured investment portfolio reduces the overall risk you are carrying. Once you have invested the upfront time and effort to set up your portfolio, your step will be lighter. Best of all, you can resume your laser focus on your prime asset – your business.
[i] According to the Center for Research in Security Prices database.
First published in the March 2018 edition of The Business Advisor.