"Invest in what you know." It's the mantra of do-it-yourself stock pickers, the reality check against Wall Street fads, the gold standard of common sense. It's also perhaps the most dangerous advice an entrepreneur can get. u Buying things you understand may be a great strategy for wage earners because it lowers the risk that they'll be wrong. But for an entrepreneur, it compounds the risk by putting more of your money in the same industry where you already have your biggest asset--your company. The result: Your portfolio might collapse at the same time your business is struggling, dealing a double whammy to your net worth.
As the current year's stock market shows, this is not a theoretical problem. For instance, do you own a tech-oriented company? Let's hope you didn't put your expertise to work in the Nasdaq market, which has plummeted 33% since its March peak. "In the last twelve months, a lot of small-business people in technology got real rich and then real poor, real fast," says Harold Evensky, a Coral Gables (Fla.) financial planner. Hubris, usually an entrepreneur's ally, can make things worse. "Business owners tend to overestimate how much influence they have over how well their company does," says Ross Levin, an Edina (Minn.) adviser. "Even incredibly well-run companies are subject to the business cycle."
The solution: Entrepreneurs need to diversify even more than ordinary investors, and put aside their hunches and insights even if they are well-founded. "I know some financial-services companies are very strong," says Janet Briaud, a planner in Bryan, Tex., "but I wouldn't invest in them because my business is related to the markets. You want to invest in something that will do well when your business doesn't do well."
That's the whole point of portfolio theory: If you own a variety of assets, with a mix of high- and low-risk holdings that don't move in lockstep, the gains in some classes will make up for the inevitable losses in others. The result is a smoother ride with less risk of an untimely plunge in your overall net worth. Better still, you'll spend less time managing your portfolio, leaving more time to run your company--and wind up richer in the end. Why? Because your company is your largest investment, and a well-run small business should produce higher returns than the stock market.
What you need is an investment plan that provides consistent long-term growth, a cushion against setbacks during your working years, and a comfortable income for your retirement--with minimal maintenance along the way. The building blocks for this strategy:
A professional adviser. This is no different from delegating other tasks that you don't have time to do yourself. Sure, it's hard to listen to your friends brag at cocktail parties about their latest stock find. But running a company doesn't leave time to run a portfolio properly, says Ed Emerman, 43, owner of Eagle Public Relations in Princeton, N.J. Emerman may soon turn over part of his holdings to a certified financial planner. Many CFPs charge fees--flat, hourly, or as a percentage of assets--rather than commissions, which helps keep them objective, and they often have a broad knowledge of different investments and tax rules. "There's a lot at stake," says Emerman, who is counting on his portfolio to provide a comfortable retirement for himself and his wife Wendy, 40, and college for their 9- and 12-year-old daughters. "And there are probably smarter people out there than I am at managing assets."
Mary Anne Graf, 53, feels the same way. "If something isn't your area of expertise, why mess with it?" says the president of Health Care Innovations, a 15-year-old hospital consulting firm in Salt Lake City. Her friends talk constantly about their winning stocks. ("All--the--time," she says in mock exasperation. "Daily. Hourly."). But Graf, who employs three staffers and 15 consultants, can't remember offhand which investments she owns. "I'm so busy. I can't keep track of this stuff. I like to take risks, and I try to keep people around me who can balance off that tendency."
In this case, it's Bonnie Cavill, a broker at A.G. Edwards in Salt Lake City. She found a unit trust that gives Graf both diversity and bragging rights. A unit trust resembles a mutual fund, but there's no portfolio turnover: It buys and holds a preset list of stocks. The downside is high cost--commissions can run a hefty 4%. But Cavill says tax planning is easier, and entrepreneurs get some stock names to drop. "It's nice for a cocktail party," she points out.
Like Graf, you might want to seek an adviser whose outlook is different from yours. "Entrepreneurs are vulnerable to buying a story from a very high-energy, take-charge financial person," says Frances Twiddy, a St. Clair (Mich.) financial planner. "The person for whom you feel the greatest affinity may not be the one to entrust with your finances."
A written investment plan. Most business owners invest haphazardly, says Marilyn Bergen, a Portland (Ore.) financial planner. "Having a written plan--a business plan for your portfolio--really helps you to stay focused when the market is driving short-term greed or fear."
A good adviser will insist that you spell out how your portfolio should be divided between stocks and bonds, what annual return you expect, what degree of volatility you can live with, what types of stock you'll overweight or underweight, and what areas you'll never invest in--such as your own industry. "If you supply windshields to Ford, for example, we'd screen out auto companies for you," Levin says. "If they do well, so will your business."
A prudent mix. That means a money-market fund or very short-term, high-quality bonds for liquidity, plus a mix of large-, mid-, and small-cap stocks for growth. If you're in a high tax bracket, short-term municipal bonds make sense. "Keep enough cash reserves to meet your overall business plan. You want to make sure you don't starve the golden goose," says William Newell, president of Atlantic Capital Management Inc. in Sherborn, Mass.
Since you have a big venture-capital investment, keep a smaller percentage of your portfolio in stocks than the average person, says Richard Stevens, a principal at Vanguard. "If you're someone who'd normally invest 80% in stocks, 20% in bonds, for example, we'd be inclined to adjust it to 70/30."
If you want to spice up your portfolio with volatile investments such as emerging markets, real estate investment trusts, or commodities, keep them small. Evensky allocates 5% of the total to commodities, for example. He uses Oppenheimer Real Asset, a mutual fund designed to mimic the Goldman Sachs Commodity Index.
Once a year, rebalance your portfolio to return to your original allocation. In other words, sell some winners, and buy some losers. "Think of it as taking some of your profit to buy things that are on sale," says Bergen.
Broad-based mutual funds. Buying such funds is the simplest way to get a diversified portfolio, and the cheapest if you use index funds. The latter don't pick stocks. They just buy whatever is in a broad market gauge such as the Standard & Poor's 500-stock index, which eliminates most costs associated with management, research, and trading. True, you'll never beat the market, but you'll virtually match it--and over the past decade, that's better than 80% of all diversified mutual funds.
Don't limit yourself to the S&P 500, which represents only big-cap stocks and is now heavily skewed to technology. Several sponsors offer small- or mid-cap index funds and funds that track the entire stock market. Look for tax-managed funds that avoid transactions that might create a big capital-gains bill. Vanguard's Tax-Managed Capital Appreciation Fund, which tracks the Russell 1000 Index, hasn't paid a capital gain since its launch in 1994.
Does this mean you can't do any of your own investing? Of course it doesn't. The trick is to limit your play money to a small percentage--perhaps 10% to 20% of your portfolio--so that you can't do any serious damage. Look at Emerman of Eagle PR. He holds a perfectly sensible mix of Fidelity mutual funds, a few riskier sector funds, some government bonds, and utility stocks given to him by his dad. But he also owns shares in Dell Computer, Cisco Systems, and General Electric. "They're fun," he says. "For the most part, mutual funds are rather boring. And although I wouldn't say there's peer pressure, when you're around others who are involved in individual stocks, it kind of seeps into you."
More often than not, though, entrepreneurs are disappointed by stocks that they "know," because their knowledge often turns out to be superficial, warns Ron Roge, a Bohemia (N.Y.) financial planner. "They base their opinion on customer service. They haven't seen the balance sheet and the income statement or talked to management. They just don't have time." Such entrepreneurs would be better off spending time on their own company, where returns are higher, and they're intimately acquainted with the balance sheet and management. It's the one case where "invest in what you know" looks like a sure thing.