Is it possible to invest too much in your company? Deborah J. Lucas thinks so. A professor of finance at Northwestern University and an expert in the investing habits of small-business owners, Lucas estimates that most entrepreneurs have more than half of their wealth tied up in their companies.
The problem: By failing to diversify, entrepreneurs put their personal financial health at risk. Lucas recently spoke to Naween A. Mangi about her research. Some edited excerpts:
Q: What are the biggest investment mistakes entrepreneurs usually make?
A: Plowing all their money back into their own company is one. Another is investing in their friends' companies in the same sector. For example, you see a lot of Silicon Valley folks buying their friends' companies and doubling their own risk. That's a bad idea. Last year's history shows that you can lose a lot of money really quickly.
Q: What investment strategies should they be adopting?
A: You diversify by investing in other sectors. To the extent you can hold other investments, try to find offsetting risks. It's much more prudent to search for investments that will move up when your company moves down.
Q: But what are they risking by not diversifying?
A: Entrepreneurs depend heavily on their own money to finance their companies. If they make risky investments, they will find themselves in a situation where they don't have the money to put into their companies. Diversification gives them the resources to continue.
Q: When they're building a portfolio, what factors should entrepreneurs consider?
A: Access to the capital markets is one. You can afford to take more of a risk in investing if your business can easily get bank loans and you don't need to access your own assets as much. If your business is extremely risky, you might want to hold the rest of your portfolio in much-lower-risk investments. The issue is to think about average overall risk, to think about your business and the rest of your portfolio in a more consolidated fashion.
Q: Shouldn't a well-run company produce higher returns than stocks?
A: Data suggest that it's not true that your company will produce higher returns. In fact, failure rates are very high. Small companies do not get better returns. Returns are either the same or lower. Plus, it's riskier.