Needed wide range of assets

Let’s start with a simple truth. To generate wealth, you must concentrate. To preserve wealth, you must diversify. As an entrepreneur, you need total focus.  

Many people have interesting business ideas, but you’re the one who actually takes that interesting business idea and turns into revenues, creates jobs, serves clients and makes a difference.  

You can only do that with an obsessive focus on one thing. Once you’re a large company then maybe you can add on other businesses and expand, but by then you’re the chairman of the board, with line managers to execute the strategy for you. 

To execute your vision, you need to focus your thoughts on just one thing.  In investment terms, it’s called “concentration”: putting everything on one bet, or “concentrating” your risk.

Initially, you have no interest in managing your wealth.  All your financial resource goes into getting your business off the ground.  You have less money in your pocket than your friends in dull desk jobs.  

Then the business starts to work; you have some catching up to do after months and years of zero personal consumption — new suit, new car, new home — only when your business is stable and your material needs are well met, do you start to think about personal finances.

So for most entrepreneurs, thinking about caring for their hard-won wealth — about stabilising their family’s finances independently of their business, about passing that wealth on to the next generation, or funding a philanthropic endowment — is a relatively late-stage concern.

While for investment professionals diversification is their mantra drilled into them throughout their careers, it’s anathema to the entrepreneurial mindset.

To all entrepreneurs out there — this is why we diversify investments: Any investment (a stock, a mutual fund, a hedge fund, a property, a share of someone’s business) is a risk.  We do our best to mitigate those risks by doing our research first. We always invest with the anticipation that our investments will do well.  But we have surprisingly little control over the actual risk we take.

We never have as much understanding of our investments as the people running them.  And even they are not in control of the business and economic environment, let alone unforeseen negative events, or heaven forbid, fraud.

However much research we do prior to investing, things can go wrong — which means, we might lose our hard-earned money.

Investment professionals who look after other people’s money are acutely aware of the responsibility that comes with their vocation. 

They know that one of the most powerful tools to protect their clients’ wealth is diversification.  The opposite of concentration, diversification means holding a selection of investments that naturally behave differently from one another.   

Any number of holdings greater than one will create some level of diversification, but as a rule of thumb, you probably should be able to count five-10 very different assets that you own, in order to feel well protected.

Let’s say you hold shares in a commercial bank that makes its living from taking deposits and lending out money to clients. If interest rates were to fall, it would probably be less profitable as in a falling interest rate environment the spread between deposits and loans tends to narrow.  

However, if you also held shares in a house, falling interest rates might make it easier for homebuyers to get a mortgage and hence the firm might be more profitable.

In practice, a portfolio of shares offers only moderate diversification, as stock markets have a tendency to rise or fall across the board and the business conditions affecting each listed company are often less important than the overall movement of the stock market.

That’s why smarter investors will invest in a much wider range of assets than just shares. The more “different” the assets within your portfolio, the smoother the investment performance of the overall portfolio will be.    

A well-diversified portfolio is unlikely ever to show amazing performance over a short period of time.  But it will be resilient to shocks, and is likely to show consistent performance over the long haul, which will increase your wealth better than occasional star wins.

You probably think that your grandparents’ love affair with gold is quaintly outdated. But gold is an interesting diversifier to financial assets, as its price tends to rise when there’s sudden uncertainty in financial markets.

Real estate tends to behave differently from financial assets. It’s hard to buy and sell quickly, so price moves can be correspondingly slow; in any case price moves are driven largely by demographic demand and the yield from rental income is also a stabiliser.

You might have heard of “alternative investment”.  Although many commentators might include assets like gold and real estate under this list, these investments are often professionally managed portfolios that take a sophisticated approach to risk management.  The result is a fund that invests in financial assets, but does not behave in the same way as a financial market and in particular, offers less risk.  

Another “alternative” would be private equity or debt  —  investments that are like the stocks and bonds that you can buy in a financial market, but that are unlisted. This makes the investment much less dependent on the actions of other investors and the lack of liquidity means that valuations are generally lower.

So, thinking like an investor, an asset owner, you’re going to make financial decisions with a very different mindset than the mindset that worked for you as a successful entrepreneur.  

Either do your homework or find a good financial advisor who can help you make that mental leap.  

Author is director, Chartered Alternative Investment Analyst Foundation