As author and financial adviser Nick Murray says: you should never have so much money invested in something that you will either make an absolute killing out of it – or be killed by it.
That’s what we’re looking at today: making an investment that could take you to either end of the financial spectrum (really wealthy, or completely broke). When we talk about ‘business risk’, we are not talking about market volatility. That’s completely different – that’s when the entire sharemarket drops. Business risk is the risk you take when you invest in just one company. This can be problematic if, for example, that company goes bankrupt, taking the value of your investment to zero.
You should never invest such a big portion of your net worth that an outcome can, as Nick Murray said, make a killing for you – or kill you. That would be a bit like going to the races and putting everything on one horse.
Business risk is sometimes called ‘under-diversification risk’. We always recommend diversifying your investments, because when you invest across multiple companies, while the volatility risk is there, the sharemarket historically recovers after a drop. In the current pandemic, the Australian market dropped 37% and has since more or less recovered. But if you had invested in a single travel company (which perhaps had been doing really well before the pandemic) and it went bankrupt, you’d have lost your money. But if you diversify your portfolio – it doesn’t matter which company makes the profit in the market – you as a shareholder will benefit.
One of our favourite sayings at Money Over 50 is ‘you can’t get rid of risk, you can only shift it.’ But this is not the case for business risk. The only risk here is your portfolio not doubling in 6 months. If you are really keen to invest in a single company, we suggest only putting a small amount into it. So, for example, if you put 10% of your retirement savings into that one company, you won’t ‘make a killing’, but it also won’t ‘kill you’ – if you lose it all, you are still left with 90% of your money.
The same actually goes for the property market, too. Often people buy property in the same suburb, or even the same street. The issue with that is that both properties are then exposed to that city’s economy. You can reduce this risk by buying a fraction of an Australian property portfolio (or even an international one) through REITs (Real Estate Investment Trusts).
We’re not saying don’t go to the races and have fun – we’re just saying don’t put everything on one horse!
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Dallas Davison, Michael Hogue and Ali Hogue.