The content of this newsletter was originally published on CPBJ.com.
I was playing golf with a friend a few weeks ago. We have known each other for a couple of years and met through our mutual involvement in philanthropy. He is a very successful business owner who started from scratch and now has revenue in the mid eight figures. Our conversation turned to the stock market and how well it’s done recently. When I said he must be happy with his accounts this year, he told me he doesn’t invest in stocks.
This is not the first time a business owner has told me this. The irony is that stocks represent ownership in businesses. It would have been more correct for my friend to say he only invests in one stock – his own business. However, I know he doesn’t look at it that way. He explained that he holds excess income in cash until he comes across an opportunity to expand his business or buy income producing real estate. He told me he can make more money investing in his business than in the stock market. That’s why he doesn’t invest in stocks.
I’m not a psychologist, but I think the psychology of how people view ownership in their business differently than any other type investment would be a fascinating study. As a financial planner, I see a huge disconnect between business ownership and investing.
Four Reasons to Diversify
I own a financial planning business. It was an early goal to be able to diversify away from ownership in the business and return on investment was not the motivation. Investment outside of a business is necessary for several important reasons:
1. Diversification
Every investment book ever written probably has a chapter on diversification. “Don’t put all your eggs in one basket,” Ecclesiastes 11:2, “Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land.” Most people know intuitively that putting all your money into a single investment can be risky. However, many business owners see investing in their business differently than investing in a stock. I suspect being in control of the business raises their comfort level.
2. Liquidity
Business ownership is not liquid. I suspect many owners think of their line of credit as a source of liquidity. However, a line of credit must be repaid. The line of credit may not always be available especially if the economy turns sour or there is a problem specific to the business. Publicly traded securities provide a daily valuation. You may not always like the price that day but you know what your securities are worth. The sale of a business or even a partial sale takes time and money to negotiate.
3. Tax strategy
Diversifying away from business ownership offers additional opportunities to control income taxes. Setting up a retirement plan for the business provides an opportunity to defer income until retirement. Growing an investment portfolio outside of a retirement plan provides yet another potential source of income in the future. Many business sales and succession plans include payouts of the owner’s interest over time. These payments will be taxed as capital gains and interest income. An investment portfolio may provide a means to offset some of the capital gains and provide a source of tax-free income to help lower the owner’s tax bracket during the payout period.
4. Hedging Your Business Interest
Hedging is a common business practice and investment strategy. Companies who rely on raw materials to make their products hedge against price changes. Those with business dealings overseas hedge against currency exchange rates. When you have your entire future tied up in one business, it makes sense to hedge against something happening to that business. An investment portfolio outside of the business can help to minimize the possibility that any one singular event could cause financial ruin.
Stock Investments vs. Business Ownership
Finally, I want to address my friend’s objection to investing in stocks because he can make more money in his own business. I suspect this is a very common objection many business owners have to investing elsewhere. I feel it is the wrong way to think about stock investments because those funds should not be expected to produce the same return as business ownership.
When structuring an investment portfolio, we start by allocating money between equities and fixed income. We do not expect the fixed investments to produce the same return as the equities. Fixed income has less risk. The return is more predictable. It belongs in the portfolio as a store of value to protect principal during a stock market decline. Therefore, the return on fixed income is usually expected to be lower than the expected return on the equities. Fixed income has a place in the portfolio even though the return will most likely be lower.
The same rationale could be used when investing outside of the business. There is a place for investing in publicly traded securities because they can provide diversification to the business interest, liquidity, tax advantages, and a hedge against having all your eggs in one basket. The return on this portfolio should be expected to be lower because it has all these advantages over business ownership. It should be part of every business owner’s investment strategy, even though the return will most likely not be as high as the return on his or her business.
I understand that investing in the stock market appears risky compared to investing in your own business. Investing in one stock is potentially riskier than investing in many stocks. A prudent strategy should be to strike a balance between personal and business investments. Diversifying outside of ownership in a single business can be the right strategy even if the return on a publicly traded portfolio of stocks may not match that of the return on your business. Business ownership might be one of the best ways to create wealth. A diversified investment portfolio can be one of the best ways to maintain wealth.
Rick’s Tips:
• Diversification is an important technique to minimize risk in an investment portfolio.
• Publicly traded securities provide reliable valuations every day the markets are open.
• Each investment should have its own return objective and should only be compared against similar investments with the same risk characteristics.
The content of this newsletter was originally published on CPBJ.com.
