Minimizing Concentration Reduces Financial Risk

Key Takeaways:
  • De-risking from your own business may seem counterintuitive.
  • Diversification can give you flexibility and liquidity.
  • Do not put your eggs in one basket.

 

Many business owners have nearly all their wealth tied up in the company. But while this concentration can be a source of pride, it also creates significant financial vulnerability. Diversification is a key tool for managing risk in personal finances as well as in business, so investing in financial instruments outside of your business is an effective strategy to broaden your portfolio, reduce risk and create financial flexibility.

This may seem counterintuitive if you have always thought of your business as the key factor in your wealth-building plan. But businesses sometimes have unforeseen downturns. Even the strongest business can be vulnerable to unexpected challenges such as legal issues, employee misconduct, market disruptions or obsolescence.

A business owner’s income stream is inherently tied to the success of the company, so if that income source disappears, the owner needs something to fall back on. Diversification can give you the liquidity to handle personal emergencies or pursue unforeseen opportunities.

Diversification also helps mitigate the unique risks business owners face. Many owners must reinvest capital into their companies to fuel growth, which increases concentration even further. By directing some cash flow into outside investments, owners can “self‑insure” against the possibility that the business may not always perform as expected.

To use an old saw — you do not want to put all your eggs in one basket.

The goal is to make sure your assets are working for you in a variety of instruments. You don’t want all your assets to be doing the same thing at the same time. Additionally, when looking at your net worth, you don’t want to see an overconcentration in any one major investment.

Here are some ways to de-risk yourself from your business and diversify your personal portfolio.

Investing and Distributing Excess Cash

  • Workplace retirement plan — Although it’s still within your company, a 401(k) plan or a SEP IRA builds tax-deferred savings that is buffered from the fluctuations of your business finances because your money is contained in a separate account that is invested to build your retirement savings. In essence, you are using the business cash flows in your own paycheck to invest in the stock market. The funds in a retirement plan are not liquid until you are allowed to make penalty-free withdrawals at age 59-1/2, and the amounts you are permitted to contribute to workplace plans are limited.
  • Investing through a brokerage account — While a brokerage account offers similar investment opportunities as a workplace retirement account, it is not encumbered by annual contribution limits or age restrictions on withdrawals. You can invest all the money you want in a wide variety of stocks, bonds and alternatives such as real estate, precious metals and cryptocurrencies. Unlike a workplace retirement plan, these investments come with no tax deferrals, so seeking guidance from an investment advisor is a good idea to help minimize any tax exposure on your investment returns.
  • Distribute excess cash — A profitable business often accumulates cash, but holding too much inside the company can create unnecessary liability. Consider defining what adequate cash reserves are necessary within the business to cover short-term needs and distributing cash in excess of that baseline amount. Distributing cash and investing it personally can de-risk you from the business and improve your personal liquidity.

De-risking your Portfolio

Besides diversifying your investments beyond your business, paying down debt is another way to de-risk your financial portfolio, including in your business. Paying down debt — whether business or personal — is a way to diversify wealth, as it creates equity.

Another option is to sell a minority interest in your business. Say you are 50 years old and not ready to retire. Your net worth is $6 million, but your business alone represents $5 million of your total worth. That’s a high concentration that leaves you vulnerable to a business downturn and lack of liquidity.

You could sell a piece of the business that would still leave you with a controlling interest, but would give you some liquidity and would reduce your overall financial risk. This also could set the stage for a long-term succession plan.

Questions?

A business can be a significant wealth-building engine, but it shouldn’t be the only one. By investing outside the company, distributing excess cash, reducing debt and planning for succession, owners can protect themselves from uncertainty and build a more balanced, resilient financial future.

If you would like to discuss broadening your personal portfolio, contact an Adams Brown Wealth Consultant.