An entrepreneur’s wealth can be tied up with their business. However, there comes a point where they realise that whilst they may not wish to sell the company, it’s worth either getting paid a higher salary or healthy yearly dividends. In so doing, it permits them to set aside money to go towards personal investments.
This kind of diversification strategy is common with founders who are major shareholders. For instance, Jeff Bezos from Amazon regularly sells shares of Amazon, Inc. to fund other investment vehicles like Blue Origin, his space venture, and to diversify his personal holdings.
If you’re an entrepreneur who’s interested in doing something similar, then you’ll need to have a good understanding of portfolio creation and management to proceed. In this article, we run through what you need to know.
What is an Investment Portfolio?
An investment portfolio is a nifty name for a collection of investments.
With a portfolio, you’re looking at how it performs overall, not so much how well individual investments perform on their own.
For instance, a portfolio that’s 50 percent allocated to the S&P 500 index and 50 percent to a U.S. bond index is intended to provide a more balanced performance with muted ups and downs. Therefore, while stocks may decline by 50 percent one year, bonds may be up by 10 percent, leading to a portfolio that fell by only 20%.
By dividing the portfolio between stocks and bonds, it didn’t suffer a stomach-churning 50 percent haircut if it had been all equity-based. This is one of the benefits of having a portfolio, rather than a single equity-only investment leaving you vulnerable to the whipsaws of the market.
The idea is to create a plan that matches your current investment goals, along with your risk tolerance.
An investment goal is described as why you’re investing and what you wish to get out of it?
For instance, if you’re wanting to retire using the portfolio to do so, then it will likely need to grow over the years.
Often, people use the so-called four-percent rule, which suggests that a basic diversified portfolio should deliver approximately 4% inflation-adjusted per year (not include fees or taxes). While a portfolio may deliver 6-7% annually, part of this must be retained to maintain the buying power of the investments. Therefore, only 4% is withdrawn annually (based on the portfolio value at retirement) plus yearly inflation-adjusted increases.
The investment goal also has a bearing on the investment strategy too.
The investment strategy adopted can factor in asset classes (categories of investments such as stocks, real estate, infrastructure, timber, etc.) and the goals that you’re pursuing. The more equity-based a strategy is, the higher the likely return. However, it also puts the capital at greater risk in the short-term due to the potential for greater exposure to the occasional, steep market declines.
When starting with an initial investment and planning to add a certain amount annually for a specific number of years, one can estimate the possible eventual return. When calculating the four percent number from the retirement nest egg, you can determine if you’ll have enough to retire on.
If there’s a difference between what you hoped to have available upon retirement and what your calculations suggest, then it’s worth considering what your risk tolerance is?
Tolerance for Risk
The risk tolerance of an investor is how much volatility of their portfolio – or individual investment within it – they can handle. It’s frequently the case that investors fail to properly think this through leading to inevitable panic selling when a market or investment drops 15-30% in a short time. The sale then locks in the lower price.
Therefore, it’s valuable to allocate enough to lower volatility investments deemed a lesser risk. These include cash, money market funds, government bonds, and other investments. Doing so reduces the ups and downs of the portfolio significantly.
Coming back to the earlier point about when investments may not grow to be worth what’s needed in retirement, risk tolerance is a factor here. Avoiding or having a low allocation of equity-based investments can lead to reduced growth rates. On the flip side, overinvesting in riskier assets can cause panic selling by being too aggressive to reach your investment goal. Every investor must make an accounting of their true risk acceptance. Otherwise, results may differ from what’s needed.
Diversification or Diworsification?
Diversification refers to dividing up investment capital into different asset classes and possibly separate sectors of the market, rather than being invested in one asset alone.
The idea is to balance out exposure to certain types of assets that may be closely or perfectly correlated together, i.e. they move in concert with one another. In this situation, when a stock index declines, a bond index may do so too.
What is Diworsification?
Diworsification is a modified term that was indicated by investor Warren Buffett to refer to investors who place money into too many asset classes and investment types. It can then end up as a bit of a muddle with an unpredictable performance due to the investment mix.
The suggestion is to invest in fewer assets and to watch them closely, rather than spread yourself widely. Also, this refers to the continued underperformance of actively managed mutual funds when tracked over a sufficiently long period.
For instance, according to JP Morgan, the average 20-year performance of surviving mutual funds versus the S&P 500 index was poor. From 1998 – 2017, the S&P 500 index outperformed the average U.S. mutual fund by 4.6%.
While some investors choose to stock pick and try to get lucky, it’s uncommon that almost anyone can beat the market. And even for those who can, their continued outperformance is never guaranteed.
Also, when you have a business to run, do you have time to research companies before investing in them? If you’re like most CEOs, then the answer is a resounding, “No.”
Enter investment vehicles.
These provide convenient ways to deploy significant amounts of capital and get it working for you.
Here are some of the types of investments:
Money Market Instruments
The money market is essentially overnight or same-day investments between corporations and sometimes other entities.
When you have a balance in a brokerage account, it may earn minor money market rates. These are often below 1% per annum. However, the funds are liquid or almost liquid because the investment matures within just a few hours. It carries minimal risk.
Exchange-traded funds (ETFs) are bought and sold on the market as if they are stocks. However, they’re a type of security where it has its own fund of investments. Typically, ETF fund reporting provides an update on both the current holdings of the fund, assets values, and the net asset value per share (NAV) of the fund. This can then be compared to the current live price of that ETF to see if it’s trading at a premium, below, or very new to its NAV.
ETFs themselves can track a specific index (a global, county, market segment, or sector). Also, they can be either indexed or actively traded in jurisdictions that permit it.
Index funds are extremely popular. They are mutual funds operated to track a specific index. This might be the S&P 500 index, a real estate index, or something else entirely.
When comparing ETF vs index funds, Wealthsimple points out the benefits of lower fees, usually no sales commission, and with index funds, the ability to have the investment closely track the market. This type of automated trading often costs a fraction of what the typical mutual fund does for actively managed investments that rarely outperform.
Exchange-Traded Notes (ETNs) are a traded security like an ETF in some respects, but quite different in others. They often carry higher expense ratios, and some have run into trouble with steep losses.
In most cases, ETNs should be considered with caution.
Closed-end funds (CEFs) are also tradeable on the market. They operate a fund within the CEF and trade actively. They have a fixed amount of capital (whereas an ETF can grow). Their capital may be leveraged which adds to the risk and the investment fees tend to be significantly higher than index funds or ETFs too.
Real estate investment trusts (REITs) are a tax-efficient investment structure where the dividend distributions aren’t subject to taxation at the corporate level.
A REIT can invest in real estate, real estate securities, timberland, pipelines, mines, and more. There are REIT index funds and ETFs.
When constructing an investment portfolio, it’s usually best to aim at either index funds or ETFs (or some mixture of the two). There are other options, but they tend to carry higher expense ratios and offer questionable diversification benefits. Newer options include automated index investing where dividend income is reinvested for you and a push to lower indexing fees compared to years past.
While Wall Street wants to sell you a highly-priced and often overvalued mutual fund or an ETN that they’ve recently issued, given that over long stretches these options tend to woefully underperform should indicate where the smart money is going. Indexing has very much taken hold because of its lower operating costs, reduced fees, no sales commission, and usually better outcomes over the long haul.
Thanks to her background writing for a wide range of start-ups, businesses and thought-leaders in a variety of industries, Ella understands the business market and what it takes to succeed. She’s always happy to share her knowledge to her readers in the form of her well-researched and thought-provoking articles.