Entrepreneurs Need to Diversify, Too
By: Cole Conkling, J.D.
As investors, entrepreneurs face a special set of needs and challenges. An entrepreneur who wants to become a smart investor (or an advisor trying to help him or her do so) faces a fundamental problem: Investing in one’s own business and investing in capital markets are two very different things. The skills that make you good at the first don’t necessarily make you good at the second. In fact, they can be a liability.
This is especially true when it comes to diversification. The case for diversification is basically this: Don’t put all your eggs in one basket. The problem is that’s exactly what many entrepreneurs did in order to launch their businesses. And if they were successful, that was a gamble that paid off. So, when an entrepreneur starts getting serious about investing, they might be inclined to make big gambles in capital markets too—and that can get them into serious trouble.
In fact, the man who originally coined the term “entrepreneur” defined it as a “bearer of risk.” Therefore, almost by definition, entrepreneurs embrace the idea of concentrated risk. Professional investors, in contrast, tend to stay away from concentrated risk. Instead, they like to spread risk around. Spreading risk is the essence of diversification.
It should be noted that the very best investors do occasionally make concentrated bets. Warren Buffett famously made his first fortune by investing 75% of his portfolio in GEICO. It was a bet that paid off. But for every success story like that, there are thousands of disaster stories. Alas, we can’t all be Warren Buffett.
Buffett is a very confident investor—but like any successful one, he is aware of the dangers of overconfidence, which causes some of the worst investing decisions. The flipside of overconfidence is overreaction. Investors who make big bets based on overconfidence are also likely to get buyer’s regret if the bet (or the market in general) suddenly goes south. That, in turn, leads to overreaction in the form of overtrading: buying and selling impulsively, rather than sticking with the investment for the long term.
Entrepreneurs have to recognize that they may be more vulnerable to overconfidence than other investors. In many cases, they are overconfident by nature. They almost have to be. As David Rose, an entrepreneur, angel investor, and author of the book Angel Investing, says, “You have to have an unreasonable level of confidence as an entrepreneur, or you’ll never get started.”
So, entrepreneurs who turn to investing need to guard against the tendency to take big risks, and the tendency to be overconfident. The two go hand-in-hand. The best protection is a good financial advisor. Think of an advisor as a speed bump: they protect you from making emotional or impulsive decisions.
An advisor can also help you build a truly diversified portfolio. Some people mistakenly see investment products like index funds as a shortcut to diversification. Yes, an S&P 500 index fund will give you diversification within American stocks, but what about international stocks and emerging markets? And what about other asset classes, like bonds, commodities, and real estate? If you’re only investing in stocks, you’ll be vulnerable to a sudden downturn in the stock market that could very well last multiple years, if not more. Real diversification spans a range of stocks and a range of other asset classes that all perform differently depending on the economic environment.
Entrepreneur-investors need to pay attention to two other things. First, they are likely to be getting a late start in the investing game. That comes with the territory. To launch a business, on your own or with a partner, you probably had to make big sacrifices and commit huge resources to your venture. You might have taken on substantial debt. Once your business is successful enough that you can start making a commitment to investing, don’t try to make up for lost time with risky investments promising quick riches. Patience is critical, no matter when you’re getting started.
Second, some entrepreneurs don’t get around to investing until after they’ve sold their business. This means you might have a substantial lump sum to invest—which can lead to taking unnecessary risks. You don’t need to jump into the market immediately with both feet. It is far better to take your time to develop a sound investment strategy.
Successful entrepreneurs bring a lot of strengths to the world of investing. They are disciplined and hard-working, and they understand value. Surrounding yourself with good advice will allow you to capitalize on those strengths, while avoiding the pitfalls of overconfidence, overreaction, and overtrading.