Small-Business Owners Require Different Investment Plan
Aug. 20, 2001 (SmartPros) Small-business owners typically focus all of their investment money, including for retirement, on their own business. Why not? It's the business they know best and they potentially can earn a far higher rate of return than they might with most investment alternatives such as stocks and mutual funds. Which is exactly why investing solely in your own business can be a bad idea, say many Certified Financial Planner professionals.
The problem is one of risk. Most investors would never put all their money on a single stock. Yet small-business owners do this routinely, with their own business. Of course, the potential payoff is huge. Just ask Bill Gates. The hitch is, for every immensely successful business that starts up in someone’s garage, dozens either fail or return only modestly. So, while small-business owners may strive for that big payoff, wise owners will diversify at least some of their investment money in case the business doesn’t earn breath-taking returns.
The first step, say CFP professionals, is to draft an investment plan, preferably in writing. Whether you do this yourself, or you work with a professional advisor, you’re looking to develop a plan that will take into account your business and that will keep your investments—and you—steady through rough times.
Another early step is to build a cash cushion for your family and your business. How much cushion depends on your circumstances. Some advisors recommend at least three to six months of cash flow. Others recommend a year or more. Typically a small-business owner will want more liquidity than the average wage earner because cash flow tends to be more erratic.
A money market is a good spot for basic emergency funds. An alternative is a Roth individual retirement account, assuming you qualify to open a Roth (no more than $150,000 in income if you file jointly). You can pull out what you put in (but not necessarily earnings), without penalty or taxes, yet if you never need the funds, they’ll be there for retirement.
Speaking of investing for retirement, consider setting up a qualified retirement vehicle at your company, such as a SEP (Simplified Employee Pension plan). It not only creates tax benefits, the assets generally are protected from creditors, which is a major concern for small business owners, who typically have all their net worth tied up in their business.
Now you’re ready to move on to higher-returning investments. This is where a lot of small-business owners get into problems, say planners. First, the temptation is to invest in companies you’re familiar with: perhaps suppliers, companies you sell to, or other companies in the same industry. The risk here is that if your industry goes into a slump, you’ll suffer a double whammy: your own business will likely slump at the same time and so will the stock of those suppliers and buyers you’ve invested in.
Another common tendency is investing in local real estate because small-business owners are often familiar with the local market and like the idea of control and investments they can watch up close. Again, a regional slump will likely pull down both your business and your local real estate investments. Small-business owners also tend to favor small-company stocks, even if they are not in the same industry, because they understand how these stocks work. To better diversify, planners commonly recommend balancing off your business investment with large-company, non-regional, domestic stocks, as well as international securities and perhaps real estate investment trusts that invest in other regions and industries.
Bonds are another important portfolio component for the small-business owner. They’ll provide a long-term security blanket for maintaining your standard of living should your business permanently falter.
The exact mix of cash, bonds and stocks will depend on your particular circumstances, age and tolerance for risk. In general, however, owners of new companies struggling to turn a profit will likely want to go lighter on equities compared with an owner running a mature, profitable business. Owners nearing retirement will, like most wage earners, want to gradually shift away from stocks toward bonds.
Whatever mix and investment vehicles you settle on, the key is to remain diversified. Your business may ultimately provide all the cash flow and retirement funds you need, but the other investments are there in case that doesn’t happen.Reprinted with permission from the Financial Planning Association. All rights reserved.