Many business owners invest their personal wealth where they feel most comfortable—which often means investments related to their core business: be that by industry, asset class or even country.
However, this understandable strategy can create cross-correlation risks between corporate holdings and the owner’s personal investment portfolio.
Imagine you're an owner in real estate and have built a successful business and deep knowledge of related businesses and investments. You've bought bonds or shares of companies you know well—you're familiar with the history, the business strategy, have a sense of management skill and therefore feel comfortable about its future performance. You, as a real estate company owner, would be more likely to buy bonds or shares to other real estate companies, either horizontally (competitors) or vertically (construction).
However, other more subtle correlation risks can occur: investing in commodities that are linked to construction or related logistics companies or some retail (Home Depot) investments all concentrate risk to real estate downturns.
This is largely intuitive—but there are also further correlation risks. For example, the real estate industry is sensitive to interest rate changes. Owners of real estate firms should be aware of having equities in other industries sensitive to interest rates, such as stocks related to consumer discretionary spending. It could make sense to have an ‘overweight’ allocation to financial services stocks—those tend to rise when interest rates rise and provides a natural hedge to the negative business impact from a risking rate cycle.
Aggregated wealth reviews
This uses real estate as an example but every sector will have obvious and less obvious risk correlations between other companies and industries, and even to the stage of the economic cycle.
The key is to amalgamate all wealth together for a risk review—not managing personal savings and investments independently—either from themselves or independent of the business itself.
If there are strong reasons why individuals wish to keep a collection of assets that have this cross-correlation of risk then risk management techniques could be overlaid across the combined portfolio to mitigate risk (such as the use of interest rate swaps in this example).
Portfolios will also be exposed to location risk too, either regionally or within the US more broadly. Personal investments can get exposure to other regions that the business cannot and it is important that individuals diversify wealth exposure to other regions. However, this can add another layer of discomfort as many will have little knowledge of investments in other regions, countries or even continents and so, therefore, their perception of the risks of such investments is greater than the reality. There are all sorts of assets for different risk appetites and experts can help diversify location risk through either onshore and offshore products.
Diversification and risk
Diversification strategies should ease concentration risks but the first step is being aware of the inherent investment biases that can be at play. This is where independent advisors come in: they can provide an expert and bias-free investment solution that minimizes and mitigates risk correlations.
It should be noted that diversification means different types of risk, but not necessarily adding risk to the portfolio.
As well as identifying the concentration of risks, the review of the cross-corporate and personal investment should also incorporate a sense check on the risk sensitivity of the portfolio (as well as the tax efficiency of the structures used).
Depending on the time horizon of the investors’ expectations and the required outcome for investment performance, it may make sense to increase the allocation of higher-risk investments that will not only bring diversification but also higher potential returns.