The Delicate Art Of Investing

What's right for wage slaves isn't right for entrepreneurs. They need a strategy all their own

Twenty years ago, Steven Smith shoveled all his cash into just one investment: his company, Tec Laboratories Inc. At first, it was because he needed every dime to build the Albany (Ore.), manufacturer of over-the-counter skin medicines for poison oak, poison ivy, and head lice. But later, after Tec Labs had grown, Smith was reluctant to invest elsewhere. "Even when I took money out," he recalls, "I didn't feel it was mine--I never knew when the company would need it." Today, after more than a decade of 20% annual growth, he expects to double revenues again in a few years, from their current level of nearly $10 million. So has success given Smith an itch to invest elsewhere? Hardly. "For a successful entrepreneur, a dollar in the business can return 300%, 400%, 1,000%," he says. "It's very hard to wean yourself away from that heady return."

Indeed, it's hard to argue with that kind of math. But as an investment strategy it leaves a lot to be desired. Why? Because your money stays right there, in a single, illiquid, relatively risky company that's concentrated in only one industry and usually one region. That breaks all the rules of prudent investing. Ideally, you should invest in a wide range of stocks and bonds, in the U.S. and overseas. Diversification is a cornerstone of modern portfolio theory because it protects you against setbacks in any single asset class and increases your chances of owning at least one well-performing investment.

Sounds logical, right? But just try telling that to a successful entrepreneur who has built a business thanks to high tolerance for risk, a hands-on management style, and confidence in his own abilities. William Newell, president of Atlantic Capital Management Inc., a Sherborn (Mass.) financial adviser, notes that the market is traditionally driven by greed, hope, and fear--and most entrepreneurs just aren't scared enough to be good investors. What's more, most off-the-shelf financial advice from books and magazines is written for wage earners. It does not take into account the lopsided risk profile of business owners, so even the most carefully crafted asset-allocation plan could be disastrous for you. Relying on stock-picking truisms such as "Buy what you know"--companies you deal with every day--might exacerbate the problem if you wind up concentrating even more money in your own industry or region. And the owner of a developing company has no business dabbling with the "10 hot stocks to buy now."

What entrepreneurs need is an asset-allocation plan that recognizes two key points. First, as a business owner, you're already taking on all the risk you can handle. Second, you want simple investments that don't involve a lot of maintenance, because time spent stock-picking takes time away from your highest-returning investment. Think of it this way: Business brokers say that if things go right, you'll make 20% to 40% a year from the rise in value of your company. By contrast, even in the past 10 halcyon years, the stock market has averaged less than 17% annually. That said, you still need to invest outside your business--not to earn a higher return, but to reduce your risk, secure your retirement (chart), and still have enough cash for your everyday personal affairs. The trick is to construct a portfolio designed to compensate for your company-rich, cash-poor profile. Here's how it might work:

Cash. Like any other investor, you first need to make sure you've got enough cash to pay your routine bills before you make any investments. But you need more liquidity than the average wage slave, because your income is less certain, says Newell. He recommends keeping "a bumper zone" of three to six months' living expenses in liquid investments. "I often encounter resistance from entrepreneurs," he adds. "They say: `That money's not doing anything for me."'

If that's your reaction, think of this money as an emergency fund. Remember that the success of your business depends on its staying power, says Harold Evensky, a financial adviser in Coral Gables, Fla. "You need a liquidity reserve so that when times get tough, you don't have to worry about supporting your family while you're trying to support your business," he says. But don't go overboard and stockpile cash, warns Larry Elkin, a financial planner and tax accountant in Hastings-on-Hudson, N.Y., or you'll wind up with a barbell portfolio: "At one end, your company--an undiversified, illiquid, somewhat risky investment--and at the other end, a money-market fund." At most, Elkin says, you need enough liquidity to cover your cash-flow needs over the next year or two.

Where to stash it? Just about any money-market fund will do. But if you're looking to squeeze out a little more yield for only a little more risk, put half your cash in short-term corporate-bond funds with one-to-three-year maturities. We screened Morningstar's mutual-fund database for short-term portfolios that consistently ranked in the top 10% over the past five years with low volatility and low expenses. On that basis, a good choice would be Montgomery Short-Duration Government Bond Class R (800 572-3863). This no-load fund boasts a 6.63% annualized five-year return and has at least 65% of its holdings in federally backed issues. Put the other half in three- and six-month Treasury bills with staggered maturities, so that fresh cash becomes available each month. Skip your broker and establish a TreasuryDirect account through the Federal Reserve ( It works much like a brokerage account: There's no commission and usually no state or local tax.

Bonds. We're talking quality paper here, not junk. This is your insurance policy against complete failure. "If your company is worth $2 million, at least 20% to 30% of your other assets should be in fixed-income investments," says Evensky. Don't get hung up on their modest returns. If your company's value doubles or triples, you won't care how your bonds did. But, he adds, "if its value drops from $2 million to zero, you'll need the bonds to maintain your standard of living." Evenksy favors municipal bonds in a taxable account and short-to-intermediate corporate-bond funds in a retirement account. But pick bond mutual funds carefully. Unlike actual bonds, these have no maturity date, so you might not recover all your principal, and the amount of interest income can vary as the portfolio changes. High annual fees can cut the return even further. Look for an index fund such as Vanguard Intermediate-Term Corporate Bond (800 662-7447). Like most other Vanguard funds, it has no load and very low expenses, with a 7.65% five-year annualized return. Among actively managed funds, we set our Morningstar screen for slightly longer maturities and turned up Monetta Trust Intermediate Bond (800 666-3882). This no-load fund posted an 8.10% five-year annualized return. Its record since inception in 1993 has held up even when bonds were weak--the worst performance over any 36-month period was a 5.43% annualized gain. Or consider buying intermediate notes directly from the Treasury.

Stocks. You run a small, undiversified, mostly local operation. So you should balance it with an array of mostly large-cap companies that have national or even global markets. The easiest way to do this: Buy index funds. They're broadly diversified, inexpensive, and not sexy enough to distract you from running your company. Yes, they're boring--but the returns aren't. Even with this year's lackluster performance, index funds tracking the Standard & Poor's 500-stock index have still beaten most actively managed stock funds in the past decade.

Nevertheless, entrepreneurs love individual equities, especially risky, small-company stocks, both from natural affinity and because their focus is on return, not risk reduction. Rather than deny this inner urge to invest, it's probably better to include it in your overall plan. Some advisers recommend putting a small portion--say, 10%--of your assets aside as "play" money that you can trade at will, while the rest goes into more structured investments. For advisers, the challenge is to come up with something better in terms of both risk and reward than what an entrepreneur can do himself. "I have car-dealer clients who carry inventory loans at very favorable rates," says Steven Kaye, president of American Economic Group, a financial planner in Wachtung, N.J. "They want to buy technology stocks. They say: `If I want a boring investment, I can get 9.5% guaranteed on my money by paying down my inventory loans. Can you beat that?"' Kaye thinks you can, with a portfolio of consumer staples--stocks that weather recessions well--that he expects will earn 7% to 15% if held until retirement.

Business owners also like investing in companies they know personally. Steven Smith, for example, owns stock in chain drugstores and other retailers that this company does business with. "I've had the chance to see and hear things that indicate whether or not they're well-managed," he explains. By all means, rely on your insight--but don't buy companies that react to the economy the same way yours does, or whose setbacks would hurt your revenue. An entrepreneur who sells to the microchip industry might want to avoid the stock of Intel, or else he risks a double whammy to both his income and his assets when that industry goes into one of its periodic swoons.

The same caveats apply to regional diversity. Entrepreneurs often invest in real estate for cash flow, capital appreciation, and personal control. Take Dan Thompson, president of Vend Alaska, a vending machine company in Anchorage. Thompson has about half his net worth in his company and the rest in local properties and in the stock of a local bank where he's a board member. "It's an investment that I can shepherd," he says. "I have some control over my destiny. I'm an active participant." And he recently bought shares in the National Bank of Alaska to spread his risk across the state.

That's a step in the right direction, but it doesn't go far enough, says Elkin: Thompson should invest outside Alaska. His company, his real estate, and the bank are all likely to suffer in a local downturn. REIT mutual funds or bonds are a more liquid and diversified source of cash flow.

But the biggest problem may be the reluctance to delegate. "Entrepreneurs are too damn busy running their own business to follow stocks or mutual funds," says Jane King, a Wellesley (Mass.) financial planner. "I've taken over 401(k) plans that were all in cash. The business owner says, `I'm gonna get to that someday....' The intentions are fabulous, but it never gets done."

Steve Smith says he has gotten past that. He's still managing his stock portfolio, but he recently turned his retirement account over to Marilyn Bergen of Portland's Capital Management Consulting. "We use a lot of index funds," says Bergen, "and I tend to underweight small company stocks for a small business owner, especially if the business is worth a great deal more than the rest of the portfolio." Says Smith: "It's worth paying half a point to have a professional manage the account. When I'm working on something with a potential 1,000% return, I don't want to get distracted by something that pays much less." That's the beauty of a strategy for entrepreneurs: It lets you spend more time and take more risk on the one investment--your business--that's likely to pay off best.

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