Help former entrepreneurs adjust to investment risk

It can be hard to change jobs, especially if it involves shifting to an entirely different industry.

And that’s exactly how an advisor needs to view the situation when working with a business owner who’s just sold his company, says Tom Trainor, managing director at Hanover Private Client Corp.

While some entrepreneurs transition to retirement more easily than others, all are vulnerable because they’re shifting from one vocation, where they keenly grasp the business risks, to long-term portfolio management, about which they may lack knowledge.

“There are two components to risk. There’s the financial capacity for risk and the emotional tolerance for risk,” Trainor says. “Because [dealing with a portfolio] is [like] a new industry for them, it’s usually the emotional side that they have difficulty dealing with.”

Case in point: when entrepreneurs talk about market corrections, they’ll frequently assert their own businesses didn’t lose a dime’s-worth of value in the downturn. They’re incorrect, but what they’re revealing with that statement is their comfort with a set of circumstances in which the value of what they own (and which provides them an income) isn’t being marked-to-market every single day.

“So, even though they could have had massive corrections in the value of their businesses, they weren’t interested in selling at that time so it was all moot,” says Trainor. “Nobody actually went in and did a valuation to tell them they were 40% poorer.”

The assertion also speaks volumes about entrepreneurs’ notions of control – they’re more comfortable in environments in which they can respond directly to risks. And stock markets have fewer control levers for individual investors who do businesses being run day-to-day.

Getting a handle on this train of thought can help advisors teach former entrepreneurs a critical lesson for their transitions: the dangers of concentration risk.

Having had all their money tied up in a business provides a springboard to a conversation about what would’ve happened to them financially if the business went under. From there, it’s a short walk to a discussion on the dangers of having too much capital invested in a single stock, and the benefits of diversification.

“After they sell, they are actually diversifying and de-risking their [capital and their] investment portfolios,” says Trainor. “Risk drives returns, there’s no question about it, and it’s the reason they’ve been able to accumulate as much wealth as they have. And now the diversification, and creation of an asset mix, is helping them maintain it.”

The lesson doesn’t always take, and Trainor notes a lot of entrepreneurs are drawn to illiquid, high-risk investments. It’s natural. At one time in their lives they were on the asking end of the capital-for-growth transaction, so they empathise with a good story and don’t focus on the 10 or 20 things that could go wrong.

“And they can’t understand why we don’t think that investment is the best thing since sliced bread,” he says. “I’ve got one guy in particular, a very successful entrepreneur, and he was zero-for-10 in tech investments that he thought were all just home runs. He spent $500,000 on the most expensive master of finance program that you could find.”

This tendency to bring investment ideas to an advisor, and push for them, sheds light on another entrepreneur trait – difficulty in delegating. Handing over their life’s savings is a challenge; and even those who admit knowing little about investing often insist on making the final call.

“Those who were good delegators in business are great clients. But those who were hands-on operators are nightmares. It just doesn’t work for them,” says Trainor. “And I totally understand and respect that. But if it doesn’t work out on the discretionary side, you have to find somewhere to put them so they don’t blow up.”

Which means it’s up to advisors to identify a client’s financial capacity, and determine if there’s any surplus capital to make more speculative investments. “That way, if they end up losing 100% of it,” he says, “that doesn’t impact their lifestyles or whatever goals they have.”

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Philip Porado is a veteran Toronto-based journalist who specializes in financial and business topics. Prior to immigrating to Canada in 2004, he covered brokerage compliance, real estate, housing policy, architecture and technology for several U.S. publications.