A variety of behavioral studies have shown that investors have a tendency to cling to their existing holdings, valuing them more highly than they would an identical opportunity to buy a different company. This loyalty – or infatuation – is not always healthy. Entrepreneurs should be alert to the fact that they may be especially susceptible to this problem.
It’s only natural that people who form companies or otherwise actively participate in the management of growing ventures should lose their objectivity to some degree. After all, the commitment of time, energy, and creativity required to make a venture successful is not a casual thing. At what point, though, does commitment become an unhealthy obsession – and how can investors in closely-held companies avoid that extreme?
When does buy and hold go too far?
There is no doubt that patience is a virtue in investing. All the same though, there are also times when stubbornly holding onto an investment can become destructive. Experienced investors have probably observed this type of behavior in others – and perhaps in themselves. The following are three examples where patience with an investment crosses the line and becomes unhealthy.
Extrapolating success. When an investment is a success, it is easy for investors to project that success into the future and expect the heady growth rates and returns to keep coming. However, growth momentum is not only difficult to maintain, but success itself can become an obstacle. The bigger an enterprise gets, the tougher it is mathematically to repeat past growth rates. A sufficient stream of new talent to sustain growth is not always available. Inevitably, success attracts competition. Meanwhile, success also pumps up valuations, so to some extent future growth is already built into the price, diminishing the potential additional reward for holding on. In short, success should be enjoyed, but it should not become a reason for you to get overly attached to an investment. Success should also be viewed critically.
Disproportionate wealth. For closely-held companies in particular, another by-product of success can be that the company becomes a disproportionate part of the investor’s wealth. An entrepreneur who started out with limited means can suddenly find herself worth millions – on paper. That success is likely to make a person feel wedded to the company, but at some point it is wise to look for the opportunity to diversify.
Refusal to admit defeat. The above are two examples of how success can make a person overly fond of an investment. The flipside is the refusal to cut losses and dump a loser. Certainly, it pays to ride out some setbacks if the long-term prospects are still good, but those prospects have to be thoroughly re-examined with a fresh eye. There is a saying in the art world that the more a collector pays for a forgery, the more likely he is to believe it is genuine. So it is with some investors – the more the losses mount up, the more they believe the company will turn around and they’ll be proven to have been right all along.
While all investors are prone to the behaviors described above, entrepreneurs are perhaps especially susceptible to them because not only is their money wrapped up in their holdings, but their day-to-day efforts and their reputations are as well. Here are some ways to achieve the necessary detachment to avoid holding onto investments for too long:
Set price targets in advance. Think ahead about your goals for the company, and what valuation you hope to achieve. Reaching that target should not necessarily precipitate a sale, but it should cause you to assess the likelihood of the company becoming worth even more. In other words, defining what success would be in advance will help you recognize success when it comes along.
Set condition triggers. Of course, some investments never reach their valuation targets because their operational performance fails to meet expectations. As an entrepreneur, you understand what conditions are critical to your venture’s success, so be ready to reassess your investment if one of those conditions changes. The loss of a privileged supplier relationship, for example, or the entrance of a well-resourced new competitor may change conditions enough to trigger a sale before the company suffers too many consequences.
Always have an eye open for alternatives. Perhaps the best way to avoid falling victim to inertia as an investor is to always be alert for new opportunities. Current holdings should not be effectively grandfathered into your portfolio – they should only remain if they continue to represent superior return potential compared to other available opportunities.
A peer-group community like TIGER 21 is a good place to find this type of objectivity. Talking to other successful entrepreneurs about your own and their ventures can help clarify just how sound your growth prospects really are – and whether there might be better opportunities available elsewhere.
President & CEO of TIGER 21