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Shannon Lee Simmons, a Toronto-based financial planner and financial blogger. (Tim Fraser/The Globe and Mail)
Shannon Lee Simmons, a Toronto-based financial planner and financial blogger. (Tim Fraser/The Globe and Mail)

DIVERSIFICATION

The big blind spot that business owners face Add to ...

Business owners are a unique breed. They take financial risks to launch companies that, statistically, have little chance of success. Their creations become more than investments – they’re almost like family members. Hence the saying “my business is my baby.”

But even the most successful owners often have a blind spot – personal financial diversification. They hold most of their wealth in one or two assets, such as their business or personal real estate holdings. And they can be stubborn about mitigating that risk.

“Depending on what stage they consider themselves at, you can talk to [business owners] about diversifying risk until you’re blue in the face, but they won’t listen,” says Jason Abbott, a financial advisor with the retirement planning consultancy Wealthdesigns.ca in Toronto. “If they’ve been at their business for a while and have seen progress, they’ll always have a sound argument as to why they’d rather assume the risks they know well, as opposed to the ones they don’t.”

Another common argument he hears: “I can produce a better return on investment from my own business than in the markets, or any other form of investment, for that matter.”

While that may, at times, be true, a non-diversified asset mix invites major personal financial risk. Why? Businesses are cyclical, and recessions, structural changes in an economic sector and technological upheaval can shrink market share virtually overnight.

Consider autonomous vehicles, which are poised to transform transportation logistics in the next decade (or sooner). Or the ongoing automation of the manufacturing sector. While many business owners will seize opportunities to build greater wealth with these tech-driven seismic shifts, others will be left behind, possibly to their personal financial detriment.

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As any investment advisor will stress, putting all of one’s financial eggs in one asset basket is a recipe for disaster. Business owners can reduce risk by holding a variety of investments unrelated to their field of expertise.

Business owners face risk when it comes time to sell their “baby,” too.

While stories abound of Silicon Valley entrepreneurs selling their tech startups and riding off into a gloriously wealthy sunset, those cashouts are rare, particularly among service businesses that lack proprietary technologies.

According to Statistics Canada, more than three-quarters of the 1.17 million small and medium-sized businesses in this country operate in the service sector.

Because service businesses in which the proprietor plays a key role are difficult to sell, most Canadian business owners cannot expect a major windfall from a sale.

“If you own a service-based business and you are the brand, you might be able to sell a book of clients, but it may not be for that much money,” says Shannon Lee Simmons, founder of the New School of Finance, a Toronto-based financial planning firm. “We’re not talking about million-dollar buyouts. You need to know, in your industry, what the average price would be if you were able to sell [your business] down the road.”

Ms. Simmons regularly advises entrepreneurs to explore financial diversification through registered retirement savings plans (RRSPs) and tax-free savings accounts (TFSAs). She says many CEOs work with their accountants to develop tax-friendly strategies such as paying themselves dividends from their corporations – at low corporate tax rates – into their personal registered accounts, which helps to shelter them from higher personal income-tax rates.

Non-registered investments such as stocks and mutual funds also can play a role in creating a balanced portfolio that delivers long-term financial security.

“If you’re going to make use of personal finance accounts, use them as would a [non-entrepreneur] investing for the long run,” Ms. Simmons says. “If the business goes to pieces, what do I have outside the business that will make sure I’m OK?”

Mr. Abbott helps entrepreneurs skeptical about diversification understand their risk exposure by what he calls “crash testing” their financial situation.

What would happen if their business ran into a major financial hurdle such as an economic downturn or an illness that took them away from the business for a protracted period of time? Would they be able to keep things afloat?

Ultimately, a comprehensive financial diversification strategy should be dictated by an entrepreneur’s personal and professional goals.

Business owners should assess everything from their spending habits and family commitments to retirement plans before developing a diversification plan, says Graham Bodel, director of the Vancouver-based investment management firm Chalten Fee-Only Advisors Ltd.

Whatever the circumstances, Mr. Bodel urges entrepreneurs to take a counterintuitive approach by investing outside of their core industry.

“The number one thing if you’re thinking about diversification with investments, whether you’re using mutual funds or single stocks or whatever, recognize that a huge amount of your invested and human capital is already focused on a particular sector or subsector,” Mr. Bodel says.

“The starting point is to not invest in what you know about. Move specifically away from that. Because when that sector is not doing well, hopefully the rest of your investment portfolio will make up the difference.”

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