Entrepreneurs should diversify

  • Identify ways that entrepreneurs can diversify away from their main business
  • Describe why a businessman should diversify
  • Describe the advantages of liquid assets

Key Points

  • With increased uncertainty, entrepreneurs might be best placed to protect their interests
  • Most of entrepreneurs' risk is tied up in their business
  • It is important for them to diversify their dividends

This is where diversification can be a valuable tool, as it provides alternate sources of return.

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Furthermore, financial portfolios can provide an extra source of cash income, and benefit a business. Entrepreneurs who rely exclusively on their businesses to finance their lifestyles can bias decisions in favour of extracting cash flow from them to the detriment of pursuing long-term opportunities for their company.

A diversified portfolio is less likely to be damaged by setbacks in any individual security, sector, asset class, country or region. Entrepreneurs and executives can go beyond this approach. They can use their portfolios to counteract some of the potential vulnerabilities in their core businesses.

A necessary step?

There are two questions entrepreneurs should consider when deciding whether diversification is a worthwhile endeavour for them. The first being: could they maintain their lifestyle if their business failed?

Entrepreneurs usually bear considerable ‘idiosyncratic’ risk related to the challenges that their businesses face.

Such problems can strike a business even in periods when the global economy and stock markets are doing well.

Companies are exposed to operational risks outside of their founder’s control. Industrial accidents, the collapse of a major supplier or client, or a trade dispute, for example, can lead to major losses.

Entrepreneurs can often bounce back from such setbacks, but nobody wants to have to make a fortune twice. The profitability of a company may also fluctuate in a way that makes it hard to maintain their lifestyle and obligations to family and charities.

This problem can be couched in terms of liquidity, longevity and legacy.

Many entrepreneurs – especially those eager to reduce risk – may want a relatively large component of their portfolio to be liquid.

A liquid asset fund can enable business owners to meet their near-term lifestyle needs without having to make rash decisions that can impair the long-run value of their business.

Holding excess cash is usually not the best option since bank deposits do not rise in value during a crisis.

The other key question for business owners to consider is: are they missing out on other opportunities by concentrating risk? This can mean over-investment in a single company, over-reliance on a single market, over-exposure to a single currency, or over-investment in a single asset class.

If the answer to question one was no, or the answer to question two was yes, then diversifying wealth is likely a rational next step.

However, diversification is not without associated costs, therefore entrepreneurs need to consider carefully their options for how to go about funding it.

Alternatives to selling part of your company

As an entrepreneur you may be reluctant to sell all or part of your business. Doing so could reduce your control over the company, which can be particularly unattractive if your business is young and growing fast. Likewise, a sale can generate a large tax bill.