As a business owner, should the asset allocation in your investment portfolio be different?

In the morning, when you read the news on your tablet or phone, or simply browse through your favourite newspaper the good old-fashioned way, you probably cannot help but wonder how and why global equity markets have had such a good year so far. Numerous challenges, ranging from unstable geopolitical situations in a number of regions, the ongoing threat of trade wars, the historic levels of government debt and of course the longer-term structural impact of Covid-19, paint a rather sobering macro-economic outlook. With market valuations trading well above their long-term averages, it doesn’t require a pessimist to expect rather turbulent times ahead.

As a business owner, economic uncertainty will also impact your firm, albeit potentially in different ways than your investment portfolio. It is therefore essential that your investment decisions regarding your asset allocation take into account the potential interplay between your business and your investment portfolio. And before you can even formulate the right allocation, it is well worth spending time on your own and your family’s situation more generally.

Do you have a good understanding of what goals are important for you to achieve in the near future, but also in the long term? Will they constrain your ability to take on more risk in your business and in your investment portfolio? What about your general inclination to take risk? Differences in personal character traits may lead to marked differences when defining your optimal allocation of your assets.

We would like to address some of these questions in the following.

Is your portfolio ready for the next downturn?

Assessing and choosing the optimal strategic asset allocation (SAA) for your investment portfolios features some unfortunate similarities with a visit at your dental hygienist – it is usually a rather lengthy and at times painful matter and at the end of process you may wonder whether it was at all necessary.

SAA is crucial for investors as it will drive about two thirds of a portfolio’s total return over time. However, its derivation is rather laborious and yet unclear given the plethora of scientific and heuristic approaches that exist. Furthermore, it also doesn’t seem to matter a great deal given that the advertised diversification benefits have not proven to be present during periods of market distress, i.e.  when they are needed most.

Having recently lived through an extraordinary episode in the financial markets in March 2020, reinforced this feeling, particularly with those that have suffered severe losses in their portfolios. An exacerbating factor can be the fact that an investor’s circumstances were not fully understood at the outset, leading to unnecessary frustrations once markets become less benign.

This is also the context where assurances by financial advisors that their advice is ‘truly holistic’ and takes one’s personal circumstances fully into account have to be taken with a pinch of salt. The advice - more often than not – actually remains piece-meal and critical elements are not fully understood, let alone considered.

Business activities need to be reflected in the client’s risk appetite assessment

Business owning investors will be particularly prone to suffering the consequences from over-simplifying assumptions regarding their personal circumstances as theirs are unusually complex. On the most basic level, their business activities need to be factored in appropriately. Operating businesses are a substantial source of current and future income for owners and, unlike the income of an employee that is fairly steady and certain, they move much more cyclically and therefore behave more akin to equity markets.

Treating the client’s business as equity will therefore have a major bearing on the client’s ability and willingness to take financial risks. Wealth advisors that do not explicitly build the client’s business into their calculations are bound to arrive at a suboptimal SAA.

Liabilities and critical lifetime goals need to be accounted for

Even if the client’s advisor does take the business into account appropriately, the assessment of the optimal SAA will typically be based on the client’s assets alone. Incorporating both the business owner’s assets as well as liabilities will give a much more complete picture when determining the client’s risk propensity.

What sort of liabilities are relevant here? There are explicit liabilities such as the company’s outstanding bonds or the client’s personal mortgage on properties or a Lombard loan in the invested portfolio. Without taking into account the interplay between the client’s assets and these liabilities, the client will not be aware and react to the reinforcing or counterbalancing nature of her assets, leading again to suboptimal choices when building the portfolio.

There are, however, also implicit liabilities on the client’s balance sheet that need to be planned for. Most of these liabilities relate to the client’s long-term goals for her money that - in her opinion - must be achieved with her savings. This can range from basic security needs, such as maintaining a certain lifestyle until her and partner’s death, the desire to fund a certain lifestyle for her children, or simply the ability to donate a certain amount to charity.  

Objective assessment measures help avoid subjective misjudgements in risk appetite

The assessment of a client’s risk appetite is typically qualitative in nature and depends largely on the type of questions being asked, but also by how are they being positioned. The same questionnaire for the same client may lead to significantly different conclusions depending on how the questions are being framed by advisor.

Small differences can then result in starkly different SAA preferences, which will have significant implications for the client’s long-term returns. The risk profiling process with the client therefore needs to be based on a solid, research-led framework that allows for an objective determination of the client’s risk score that is subsequently adjusted for behavioural characteristics.

The GALA approach provides a specific framework for entrepreneurs 

Recent academic contributions have made helpful proposals in order to capture some of the complexities witnessed in reality. Asset Liability Management based solutions, which are more commonly used in the pension industry, have recently been adopted to address the wealth situation of individuals, in particular those of entrepreneurs.

We have adopted and expanded these in order to adjust them to the situation of our clients. We have summarised its building blocks in what we call the Goal-based Asset and Liabilities Allocation (GALA) approach. The results show that incorporating the client’s business activities as well her explicit and implicit liability positions can alter the client’s ideal risk/return profile significantly.[1]

In a recent discussion with a client - a successful Hungarian entrepreneur with a nationwide retail chain - we learned that her strategic asset allocation was heavily tilted towards fixed income investments based on the risk profile assessment by her advisor. It further transpired that neither her business operations, nor her longer-term goals were discussed in great detail. The advisor’s conclusion on the client’s risk profile appeared to be based on a limited number of qualitative questions and the notion to ‘play it safe’.

However, this may not necessarily be the optimal portfolio solution for our client as the result will vary markedly depending on the client’s liabilities or - put differently - the ‘leverage ratio’ on her balance sheet. Additionally, it will vary depending on the extent to which her business is correlated with the equity market, a measure called ‘beta’ factor where higher values show a greater synchronisation of company returns with the equity market.

During an in-depth conversation with the client, we established that the client had the desire to fund a number of long-term goals, ranging from supporting her parent’s substantial medical bills over the next 15 years to setting up a trust for her three children and funding it adequately over the coming years. These goals were incorporated as ‘liabilities’ into her balance sheet and fed directly into our risk profiling model.

Following the discussion of various model scenario outcomes, the client decided to rebalance her portfolio towards a larger equity composition. In addition, her investments were split into goal-based buckets in order to be better able to track each goal’s progress. This had the added benefit that certain higher priority goals could deploy a low-volatility asset portfolio (e.g. the bucket dedicated to the medical coverage for her parents), whilst other goals could be assigned riskier assets, balancing back to the overall agreed risk/return profile for the client.

Finding the right mix for you

Your situation may vary markedly from our client above. Perhaps, in your circumstances will require to take risk off the table, or, more likely, ensure that your investment portfolio displays a low correlation with your other business interests. We would love to talk to you about this.

Return to leadershipinwealth.com

References

Brunel, J. L. (2011). Goal-Based Wealth Management in Practice. Journal of Wealth Management, 17-26.

Horan, S. M., & Johnson, R. R. (2014). The influence of a Family Business on Portfolio Management: An Asset-Liability Management Approach. Journal of Wealth Management, 14-30.

Footnote

[1] Our GALA approach borrows from recent academic contributions of (Horan & Johnson, 2014) and (Brunel, 2011) regarding their advancements in managing portfolio with an asset and liabilities perspective. However, the GALA approach expands on the number of asset classes in order to model a more realistic investor portfolio scenario. In addition, in contrast to (Horan & Johnson, 2014), we do not incorporate business assets into the overall asset allocation using their approach. Instead we developed our own approach which includes an estimate of the company’s return, volatility and correlation profile based on the companies estimated beta relative to the equities market. This allows us to fully incorporate the business into the strategic allocation calculation.