A few years ago, Paul, a successful owner of a home-building company, wanted to reinvest his wealth in his business. The real estate market was booming and few other assets provided the kind of return he could achieve with a business that was well on the way to becoming one of the largest privately owned home builders in the country.

But Paul's financial advisor insisted that Paul build a portfolio with assets that behaved differently from his company. Paul did as advised but had his doubts. The portfolio produced steady but unexciting returns; certainly its returns weren't of the magnitude that he was seeing in real estate.

Then, of course, the real estate market collapsed. Paul's business reeled. But the portfolio held steady. The financial advisor didn't have to say “I told you so.” Paul became a believer in diversification. Unfortunately, many more still need to be converted.

People feel most comfortable investing in what they know, so business owners naturally tend to bet their wealth on investments that follow the same trends that affect their businesses. That's why it's so critical to truly grasp the expected cycle of a business owner's biggest asset.

Indeed, financial advisors also need to get true diversification religion. They should be balancing not just the portfolio in front of them, but all of a clients' holdings — including his business — and build a comprehensively diversified investment strategy. The question is, of course, how exactly should they go about that?

The Business

First, we have to identify the business as an asset in a portfolio.

Entrepreneurs often funnel all of their assets into their businesses. But, once the business is established, most owners begin to build wealth they want to preserve and pass to the next generation. Too frequently, though, the business is the elephant in the room. Few owners consider its performance behavior relative to their portfolio. Of course, by ignoring it, they remain too concentrated.

This isn't surprising. Fitting the business into an asset allocation plan is difficult. It is hard to find reasonable data for comparison, because the asset is illiquid and isn't “marked to market” or valued daily like other assets.

The next step is to create a business market index (BMI). In the same way indices are used to benchmark stocks and other assets in a portfolio, company data can be analyzed and compared to other industry data and macroeconomic indicators. This is more than simply predicting sales trends. Understanding a company's highs and lows provides important predictive data on the business' changing valuation which must be considered within the context of the other assets in the portfolio.

Naturally, different types of businesses will have different cycles. While manufacturing businesses and financial services more closely track the ups and downs of the economy, others, like law firms, are less likely to, as they're non-cyclical. To create a BMI, advisors must gather data on the market or industry in which a business operates. For example, if we know a company's sales are 50 percent to industrial firms, 19 percent to law firms, 17 percent to accounting firms and 14 percent to “other,” we can gather external data to reflect the business cycle of each identified market. The “other” category is often designated as gross domestic product or assumed to be non-cyclical, depending on its degree of cyclicality. The data can be further segmented, so, for example, industrial sales can be broken down into sub-segments, such as commercial airline and power generation if the segments are more different than similar.

Once the relevant end-market data is collected, it's standardized so it can be expressed in a common unit (generally done by indexing each data series to a common base). Advisors then apply a relative weight to each market component to calculate a weighted BMI. We can examine historical returns and the volatility of the BMI to model future returns for the business as well as to predict the ups and downs or volatility. The BMI isn't a perfect benchmark, but it can serve as a close approximation.

The next step is to create a correlation matrix that compares the company's performance to the performance of other financial assets. A correlation matrix compares data on the company (as measured by the BMI) to other asset classes, such as large cap equities, small cap equities, international equities, real estate investment trusts, bonds, cash, commodities and other indices. This matrix allows the business owner to see which assets are correlated or move in the same direction as her business. For example, by comparing her business to these asset classes, the business owner may find her business is more closely correlated to international equities and has a low correlation with bonds. (See “How Assets Behave,” p. 42.)

Knowing how a particular business performs relative to other asset classes allows the advisor to construct an asset allocation that better reflects that business' ups and downs. This means investing more heavily in asset classes with lower correlations to that business and avoiding asset classes that track or are correlated to it. In fact, business owners should even look to invest in assets that are negatively correlated or move in the opposite direction as their businesses.

The last step is to balance risk. It's critical to understand how a business behaves relative to other holdings, or, how it correlates with other types of financial assets. The goal is to avoid being overexposed or concentrated in assets that mirror a company's business cycle.

Here are the kinds of insights this analysis can yield:

  • A real estate developer, finding that most equities are correlated to the real estate market, may find that a diversified portfolio of stocks may have a high correlation with his business as many corporations have significant real estate exposure such as office buildings, warehouses or manufacturing plants.

  • If a company relies on inputs such as energy or other raw materials and finds profits squeezed when these commodity prices rise, a diversified portfolio should include some commodity exposure. On the other hand, an owner of a company in an energy business may want to restrict commodity exposure or avoid exposure to assets like emerging markets whose economies are tied to commodity performance.

  • It's important to understand the sectors that dominate returns. For example, in the late 1990s, technology companies comprised a substantial part of the S&P, meaning that investors in broad market or S&P index funds were overly concentrated, especially those with businesses in the technology industry.

  • Business owners need to balance the illiquidity of their business asset. So, even if an asset has a low correlation to a business, the asset class may need to be limited to balance overall liquidity risk.

Case Study

Consider a distribution business worth $20 million. The owner also has real estate holdings, including a primary residence and vacation properties worth $2.5 million as well as a portfolio of stocks valued at $900,000. Upon completing the sale and lease back of a building, the owner receives $4.1 million in cash. A typical recommendation for the $5 million worth of stocks and cash would be a diversified group of assets classes, including domestic and international equities, some bonds and perhaps some real estate (See “Diversification Is Good,” p. 43. )

But if we examine a correlation matrix developed using the company's BMI and compare it to Portfolio A, we see that most of these asset classes have a relatively high correlation to the business and are likely to move in lockstep.

A more diversified portfolio would include asset classes that have a negative correlation to the business (see “Diversification Is Good,” p. 43. ) Keeping in mind the business asset, a more diversified portfolio has more liquidity to balance the illiquid business and real estate holdings. While both portfolios have the same return potential, the more comprehensively diversified one obviously will better serve to preserve the client's wealth.

Clearly, the more comprehensive approach makes sense. Just as clearly, it's difficult first to get business owners to re-conceptualize their investment approach and then to craft a truly diversified portfolio. It's difficult, but doable — and absolutely essential in today's more volatile economy.


Christopher G. Didier is a managing director and senior investment consultant at the Milwaukee office of Robert W. Baird & Co., and Brian L. Beaulieu is executive director for the Concord, N.H.-based Trend Research

How Assets Behave

Some move in lockstep; others, in opposite directions

This correlation matrix shows how some asset classes move up and down together while others move in opposing directions. For example, at the extremes a correlation of 1 means that when one asset class moves up, the other class moves up by the same amount. A correlation of -1 means that when one asset class moves up, the other moves down by the same amount.

Large Cap Equity Small Cap Equity International Equity Emerging Markets Real Estate Investment Trusts High Yield Bonds Intermediate Taxable Bonds Cash Commodities Hedge Fund of Funds Sample Company
Large Cap Equity 1.00 0.88 0.69 0.61 0.59 0.53 0.18 -0.03 -0.27 0.46 0.37
Small Cap Equity 0.88 1.00 0.62 0.72 0.68 0.59 0.08 -0.04 -0.14 0.53 0.18
International Equity 0.69 0.62 1.00 0.58 0.49 0.42 0.14 -0.12 -0.18 0.38 0.38
Emerging Markets 0.61 0.72 0.58 1.00 0.34 0.50 -0.26 -0.12 -0.14 0.59 0.03
Real Estate Investment Trusts 0.59 0.68 0.49 0.34 1.00 0.54 0.36 -0.11 -0.22 0.22 -0.02
High Yield Bonds 0.53 0.59 0.42 0.50 0.54 1.00 0.27 -0.05 -0.31 0.25 0.08
Intermediate Taxable Bonds 0.18 0.08 0.14 -0.26 0.36 0.27 1.00 0.19 -0.11 -0.13 -0.40
Cash -0.03 -0.04 -0.12 -0.12 -0.11 -0.05 0.19 1.00 -0.01 0.10 -0.14
Commodities -0.27 -0.14 -0.18 -0.14 -0.22 -0.31 -0.11 -0.01 1.00 0.12 0.12
Hedge Fund of Funds 0.46 0.53 0.38 0.59 0.22 0.25 -0.13 0.10 0.12 1.00 0.34
Sample Company 0.37 0.18 0.38 0.03 -0.02 0.08 -0.40 -0.14 0.12 0.34 1.00
— Robert W. Baird & Co.

SPOT LIGHT

Victoriana — “The Squire and The Gamekeeper,” an oil on canvas attributed to James Lobley and measuring about 30 inches by 25 inches, sold for US $82,792 at Sotheby's auction “A Great British Collection: The pictures collected by Sir David and Lady Scott, sold to benefit the Finnis Scott Foundation,” held on Nov. 19, 2008, in London.