Diversification and Entrepreneurship

The most recent TIGER 21 Member Favorites Survey showed some investment tendencies which on the surface might seem inconsistent with the take-charge personality of entrepreneurs, but, on closer examination, represent a sound approach to diversification.

Members revealed a preference for passive investments, which might seem at odds with the hands-on nature of entrepreneurship. However, this might actually be an especially logical approach to diversification for entrepreneurs, as long as they remain mindful of some other diversification principles.

Passive Investments for Active Entrepreneurs

The top two equity investments identified in the latest Member Favorites Survey were both S&P 500-based exchange-traded funds (ETFs). Those are about as plain vanilla and passive as investment choices can get, but lest anyone think entrepreneurs would gravitate to more exotic and exciting investments, there is a method behind this mildness.

In their primary business ventures, entrepreneurs have holdings that are typically both highly concentrated and extremely time-intensive. Therefore, broad market indexing makes sense as a complementary technique for their other investment holdings. The breadth of an index fund considerably broadens out the risk exposure for someone with a significant amount of wealth tied up in a single holding, while the passivity of indexing allows busy entrepreneurs to achieve that broad diversification without much demand on their time.

Pitfalls of Diversification Techniques

While passive indexing makes a certain amount of sense for entrepreneurs, it is important to remember that there is more to diversification than simply owning a large number of stocks.

One oft-cited study found that mathematically, diversification could be achieved simply by owning about 20 different stocks. The premise is that the specific risks of individual holdings start to be both watered down and cancelled out when you have 20 stocks exhibiting different price change patterns. However, it would be a mistake to assume that true diversification can be so readily achieved, because there are systematic risks to worry about in addition to the specific risks posed by individual holdings. Systematic risks are not diversified away solely by owning a large number of securities.

In terms of systematic risks, it is important to recognize the sector and economic exposures of the indices you hold, because these can vary depending on the type of index. For example, a NASDAQ-based index would have more tech exposure than an S&P-based index; that S&P-based index would have more exposure to financials than a Dow-based index.

As a matter of fact, some indices can be surprisingly narrow in their sector exposure, so an entrepreneur looking to diversify must take care to choose an index which complements rather than heavily overlaps the risk exposure of any private equity ventures.

Putting an emphasis on different sector exposures is a start, but it is important to think about economic exposures as well. For example, holdings that are positively or negatively inflation-sensitive may cut across a variety of sectors, but true diversification is only achieved if the inflation exposure of passive investments differs from the inflation exposure of the entrepreneur’s primary business venture.

The Role of Volatility Dampeners

An additional note on diversification for entrepreneurs involves volatility dampeners – holdings like cash and fixed income whose role is to provide a more stable element of the portfolios.

The Member Favorites Survey showed equal weightings to two potential volatility dampeners – cash equivalents and fixed income, each of which represented an average of 12% of Members’ asset allocations.

Compared with typical institutional investors, those holdings represent a lower emphasis on fixed income and a higher emphasis on cash. The relatively small emphasis on fixed income is probably a reflection of today’s low yields, and this may well be a shrewd move. Asset allocation formulas are often based on historical returns, but logically today’s yields make those returns less relevant to asset allocation decisions. It would be reasonable to expect both lower returns and higher volatility from fixed income investments that are starting out from a low-yield position.

Of course, cash equivalents are also victims of the low-yield environment, and yet 12% would be a higher weighting compared to typical institutional investors. This is likely yet another way that diversification considerations differ for entrepreneurs. The nature of their business ventures is that they often need ready access to liquidity, and with so much of their wealth tied up in illiquid private holdings, having a fairly large cash position on the side can be healthy.

There are many ways that entrepreneurs differ from ordinary investors, and that difference should extend to their approach to diversification. For a large number of Americans, their single greatest asset is their home – essentially a passive real estate holding. For entrepreneurs, though, their largest single holding is often the company they run, which from an asset allocation standpoint would be viewed as an active, private-equity direct investment.

Because wealthier people typically have a smaller portion of their net worth tied up in their homes, it explains why TIGER 21 Members would seek additional real estate holdings in their investment portfolios. At the same time, being directly involved in the management of a private equity venture amounts to an intensely active form of investment management, which explains why they would favor passive indices to round out their portfolios.

Those approaches make perfect sense. The one additional thing entrepreneurs should be mindful of in approaching asset allocation is to understand how the sector and economic exposures of their passive investment weightings complement or overlap with those of their private equity holdings. True diversification isn’t simply about having more and different holdings; it is about making sure those holdings represent a variety of differing risk exposures. 

 

Barbara Goodstein Signature
Barbara Goodstein
President & CEO of TIGER 21

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