Picture of asset allocation for small business owners concept graph on blackboardIn an online forum the other day, a long-time member advised someone to ignore their small business when considering their asset allocation. No one seemed to take much notice. And the group discussion soon moved on to their usual arguments.

But the question got me thinking: Shouldn’t asset allocation for small business owners and entrepreneurs consider their ownership interests in their businesses?

I think so. In fact, I’d like to propose a more nuanced approach to asset allocation for small business owners and entrepreneurs. Because here’s how the landscape looks to me…

Idea #1: Standard Asset Allocation Formula Your Starting Point

Okay, first thought: I think we should all still start out with a standard asset allocation formula for all of our traditional asset class investments.

In other words, for the stuff other than the investments we’ve made in our small businesses, we try to apply a standard formula.

If you’re using a 60% stocks and 40% bonds asset allocation formula, for example, you go with that as best you can for the money you’re holding in your retirement accounts and taxable brokerage accounts.

Idea #2: Let Alternative Asset Classes Nudge Percentages

But another thought—maybe we should let any alternative investments nudge or tilt the percentages.

Let’s say, for example, that your standard asset allocation formula says you should have 15% allocated to real estate investment trusts. (One popular asset allocation, David Swensen’s, suggests this.)

Further suppose that as part of your small business or entrepreneurial activities you have 5% of your investments in direct real estate.

While it doesn’t seem logical that you would consider the 5% direct real estate investment as a complete replacement for 5% of real estate investment holdings, you probably don’t need as much real estate in your traditional assets portfolio if you’ve got a bunch in your alternative assets portfolio.

You’re probably holding real estate investment trusts as an inflation hedge, right? And you should get some inflation hedging from direct real estate investment.

In the end, then, while maybe your standard asset allocation formula says 15% to REITs, you might be okay going with 13% or 12%.

You don’t give yourself “full credit” for direct real estate investment. But you give yourself some credit.

Let me give you another example, too. Say your standard asset allocation formula says you should have 30% allocated to US stocks and that your small business amounts to 10% of your investment portfolio. Again while it doesn’t seem right to consider that 10% in your own business as a substitute for 10% of the US stocks allocation, maybe you nudge down that 30% value to 25%.

Probably you’re holding US stocks to share in the investment profits that flow from a healthy, growing US economy.  But if you’ve got 10% of your investments in a small business you own–a high-risk but also high-reward private equity investment–probably you’re already going to profit from a healthy growing US economy via that allocation.

Idea #3: Try to Uncorrelate Alternative Asset Investments

A third notion to consider…

One of the things going on in any good asset allocation formula is that you build a portfolio using different asset classes so if returns in one class zig, that’s okay because returns in another asset class zag. The returns from different asset classes are uncorrelated, in other words.

With private, entrepreneurial investments, you can’t always widely diversify. But you should sometimes be able to invest in things that aren’t as correlated. And that’s probably a good idea.

For example, say your alternative assets portfolio includes two investments: $200,000 of equity in a small business and $200,000 of equity in direct real estate ownership. If the real estate you own houses your business, that’s pretty correlated. And that’s not good asset allocation.

On the other hand if you have $200,000 of equity in a business in your home town and then $200,000 of equity in real estate located in another town or another state, that’s quite a bit more diversified.

Idea #4: Over Time Move Toward Your Ideal

A final quick thought. Small business owners and entrepreneurs will often over time tend to liquidate their alternative asset class investments like the business they own and the rental properties they hold. Probably you will too.

And what I think this means is that as liquidation events occur, you want to redeploy alternative asset sale proceeds to traditional asset classes using your standard asset allocation.

For example, if you liquidate some alternative asset for cash, you use those proceeds to make traditional asset investments and in a manner that moves your asset allocation to whatever you’ve already decided is appropriate. If you’re using a 60% stocks and 40% bonds allocation, for example, you might use proceeds to invest 60% in stocks and 40% in bonds.

As another example, if you liquidate some alternative asset for cash and an installment note, you consider the installment note to be like a bond (which is it) and then use the cash for whatever else you invest in other than bonds (probably stocks).

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