The Diversification Imperative

Owners of small and midsize private businesses may bear more undiversified risk than any other group. Starting or buying a business requires cash. Growing a business requires cash, too. Most business owners have limited funds, and obtaining additional equity or debt capital can be difficult or at least costly and time-consuming. The common result is extreme concentration of assets in the business. In doing this, the owner breaches one of the most widely accepted principles of prudent investment - diversification.

The validity of diversification is so well accepted in finance that it is sometimes called the law of diversification. It's a risk management technique. It espouses spreading around your investments among a diverse, unrelated group of investments rather than concentrating them in a single investment or a few, related investments. Diversification allows the investor to limit the impact that random and unforeseen events can have on a portfolio.

The inverse of diversification is concentration risk.

In the first days when a business is newly formed or purchased, there aren't many ways for the typical investor/owner to avoid concentration risk. Consciously or subconsciously, he or she bears that risk in exchange for the chance to live the dream of freedom and independence. Some ways to limit concentration risk at the onset include obtaining additional equity investors, securing non-recourse debt financing, avoiding having your spouse sign as guarantor, not pledging your home or other personal assets as collateral, and buying or starting a business that requires only a portion of your cash or investable funds.

But as the business grows and prospers, the opportunities to diversify improve. The prudent business owner will do so, and the Internal Revenue Service Code provides meaningful incentives. Regular allocation of company profits to owner accounts (e.g., IRA, 401(k), Keogh, SEP) can yield significant gains over time in personal financial security and risk reduction. The goal is that the quality of your retirement would be acceptable even if disaster struck your company.

We all know that private business is inherently risky. Private investment is risky. Even home prices have declined recently. To gamble your entire financial well-being and retirement security on a single, private business is a risk no one should have to bear for an entire lifetime. It may be the nature of private business ownership, but it doesn't have to be - at least not forever. Talk to your financial advisors about ways to diversify and lower your concentration risk. The Business Owner offers ideas that may be good places to start.

Copyright © 2011 by D.L. Perkins, LLC. All rights reserved under International and Pan American Copyright Conventions. Reproduction, in any form, in whole or in part, is prohibited without written permission from an officer of D.L. Perkins, LLC. Issn. No. 1556-2026. Vol. 6, No. 4. "The Business Owner" is a registered trademark of DL Perkins, LLC - Registered in U.S. Patent Office