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Most investors understand the notion of diversification. But as a business owner, there is a good chance that your diversification strategy may not work as you intended. Here's why.
Diversification 101
The cornerstone of diversification is a mixture of investments, each of which has broadly differing patterns of strength and weakness. That way, strengths in one investment can potentially offset weaknesses in another at any given time. The greater the difference in performance patterns of any two investments, the bigger the potential benefit from diversification.
Historically, alternative investments such as real estate and precious metals provided a non-correlated counterbalance in portfolios to traditional holdings such as stocks.
Over the past decade however, some investments that once differed significantly began performing more alike and this reduced their potential to offset each other's ups and downs in your portfolio. As financial instruments and global markets became increasingly liquid and accessible, different asset classes became more closely interrelated.
Correlation is Important
Correlation is the measurement of the variation in performance between two investments – the lower the correlation, the greater the potential to diversify your holdings. A correlation of zero denotes no statistically measurable relationship between changes in one set of returns and changes in another. In other words, the less alike two investments are, the less likely they are to both drop in the same market conditions.
But investors need to remember that different asset classes that once tended to correlate at a relatively low level, might have increased in correlation in recent years, so it's important to review diversification and correlations at least on an annual basis.
Consider Your Total Risk Factor
In very simple terms, many might consider an allocation of 60 percent equities and 40 percent fixed-income to be diversified. Such a setup, especially for business owners, is far too simplistic. The better approach is to:
Review your entire risk profile (which includes your business).
Not treat all equities as equally risky and all bonds as equally safe.
Make finer distinctions within asset classes.
Failing to account for the risk profile of your business can give you the appearance of being diversified, but risk factors can vary significantly based on the specific industry and tenure of your business.
Factors to Consider
The idea of diversification is to keep risk at your manageable level, right? Well, as you consider your investments and create distinctions within larger asset classes, how would you categorize your business?
Is your business:
Dependent on seasonal spending?
Dependent upon particular raw materials that fluctuate in availability and cost?
Focused on a particular sector, like health care or technology?
More likely to succeed when consumer spending increases?
More likely to improve when general economic conditions deteriorate?
Many investors are trained to think of portfolio construction as a collection of assets, which concentrates portfolio risk into a single factor, such as equity risk. But investors, especially business owners, really need to take it a step further and consider portfolio construction by risk factor, not just asset class.
The Biggest Danger
One of the greatest dangers to diversification is, in fact, your business. Many owners would rather reinvest their earnings back into their business. While this approach might be appropriate at certain times, it is really no different than investing everything into U.S. Small Cap Growth stocks, for example. The end-result is that you will have “all your eggs in one basket," and your risk profile will increase dramatically.
While it's understandable that a business owner would much rather invest in their business rather than figure out an appropriate asset allocation plan, research the changing correlations among asset classes, and categorize their business into an asset class, this approach may jeopardize the owner's financial security.
This is where working with an experienced investment advisor can help you develop an appropriate portfolio strategy based on your unique situation.
Contact us to find out more!
