How should business owners invest?

As a business owner, you often face a very different set of financial risks than your non-business owner counterparts. When it comes to investing, there are two major considerations you need to remember. First, keep your powder dry. It’s an old sailor’s term that I like to use to describe the need to keep enough money in your personal and professional finances to weather life’s storms.

The other consideration is that you probably have a high concentration risk. In other words, most of your net worth is tied to your business. For the purposes of this article, let’s assume you have enough dry powder. Let’s also assume that you are like the majority of business owners and that you deal with large concentration risk. With these things in mind, we want to answer the question, “Why should business owners invest differently?”

A huge red flag

Well, if I looked at a client’s portfolio and saw that they have 70% or 80% of their funds invested in one company, that would set off a huge red flag. This tells me that this client is at huge risk if this position were to drop suddenly. Yet that is exactly what is happening with business owners around the world.

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Moreover, business owners are so accustomed to managing risk that they often become too comfortable with it. Of course, no two situations are the same, and we all have unique perspectives and biases.

However, knowing that business owners are particularly prone to concentration risk in their day-to-day lives, we need to pay particular attention to building an investment portfolio that mitigates this risk and allows you to diversify away from your company. That’s why you need a trusted advisor that can help you keep your feet on the ground.

Now, the basic workings of investing will likely remain the same. You should always know where you are starting from (your current net worth), risk tolerance and ability, and where you want to go, financially speaking. That probably won’t change.

But each of these important elements will help your advisor build a portfolio that can withstand losses and mitigate risk through diversification, ultimately helping you achieve your financial goals.

An example of how easily concentrated risk can occur

However, investing as a business owner is not exactly like investing as an average worker, and it is essential that your advisor realizes this. A great example of why this is so important comes from someone I met many years ago. This individual was a business owner whose company manufactured widgets for the US military. When they first came to see me, they were working with an advisor who had invested their entire portfolio in defense stocks.

Despite their attempt to diversify and remove their concentration risk, they were even more concentrated. This person was receiving funds through his company through defense contracts while investing in defense stocks. After my first meeting with this person, I began to understand the importance for entrepreneurs to work with advisors who truly understand the unique situations of their business owner clients.

You see, as a business owner, you are faced with a unique set of characteristics that, from an investment and portfolio construction and design perspective, you and your advisors need to be aware of. For example, your business will generally have fewer constraints than you would find in the investment world. Often you use leverage in your business. You are involved in the business. These elements provide much rarer opportunities when investing in stocks.

This is mainly because the investment side is much more limited. This is where strategies such as hedge funds can help.

How Hedge Funds Could Help

Although people often think of hedge funds as asset classes, they are actually strategies that offer investors exposure to sources of return. In this regard, they can help remove some of the normal stresses that come with investing. In many ways, your business is like a miniature private equity fund or hedge fund. So there are alternative strategies like these that many business owners might find appealing.

Nevertheless, you must remember that the only correct strategy is the one that suits your very particular situation. Then, once you’ve selected the appropriate strategies, you need to work with your advisor to determine the best way to combine them to achieve the characteristics you’re looking for. Therefore, investing is indeed a little different for business owners, and it is important to work with an advisor who understands this.

This article was written by and presents the views of our contributing advisor, not Kiplinger’s editorial staff. You can check advisor records with the SECOND (opens in a new tab) or with FINRA (opens in a new tab).