Which investment involves lower risk: Putting your money in one company? Or buying shares in an S&P 500 index fund?
Nearly all financial advisers and many clients know that the index fund is much more diversified and therefore has less risk. Yet it is easy for clients to forget this basic fact when the chance to invest in a particular company presents itself.
When clients ask me to evaluate opportunities to invest in a private company, the stories are often compelling at first. Clients have brought me opportunities ranging from a marketing company looking to lower its costs by buying in bulk to a niche social media company looking to grow its user base. Almost all of the investments come from a trusted source, such as a long-time friend. But once I dig deeper into a company, I usually find major red flags.
Most of the time, I convince clients to pass on individual company investments. Occasionally, we agree that a small investment is acceptable. And sometimes a client will choose, despite the risks, to invest more in a small company than I would recommend.
Why does this happen?
Why Clients are Tempted to Invest in Private Companies
I see a few reasons why concentrated investments in private companies may tempt clients — even those who fully understand the importance of diversification. A personal connection is powerful. If you believe someone to be a good person overall, you’re more likely to trust him and assume that he’ll make a successful business partner too. While viscerally reassuring, this familiarity may make investors overconfident in a company’s prospects. Even with good intentions, skill, and an attractive market, unforeseen problems can still ruin individual company investments.
Clients can also get a skewed perception of the success rate of individual-company investing for the same reason that it seems like your Facebook friends are always on vacation or eating great meals: It’s fun to talk about your winners. You can see this tendency on display in the TV show Shark Tank. After a wealthy “shark” invests in a company, the producers provide updates that highlight the successes but don't mention the failures.
Financial advisers can sometimes share the blame for clients’ interest in individual company investing. We know that it’s important to focus on the big things in clients’ lives, such as how much they save and their overall asset allocation. As a result, we spend so much time talking about markets in the abstract that we sometimes forget to emphasize that markets and indices are composites of many individual companies. We talk about the forest, but clients don’t see any of the trees.
Refocusing on a Diversified Portfolio
If people are inclined to believe that the market as a whole is overvalued, it can be hard to convince them to invest broadly without telling a good story, with identifiable characters. Even if you allocate to broad index funds, that doesn’t mean there’s no story to discuss. Individual companies like Apple, Exxon or Procter & Gamble are large components of the S&P 500 that can easily make the investing story relatable for clients. While one company’s impact on a portfolio is likely negligible, discussing it in more detail can improve clients’ understanding of their investments and remove the false impression that private companies are the only ones that prosper.
If a client is insistent on a more concentrated portfolio, adding a small stake in a private equity fund might be an attractive alternative to directly investing in a private company. Although these funds are riskier than mutual funds, they still incorporate professional management and some diversification.
If a client wants to pursue individual company investments because they’ve gotten wrapped up in a compelling story, remind them that the most interesting investing stories can often result in expensive lessons. Discuss the specific investment’s risks, mention the biases that may be influencing their behavior, and — if all else fails — consider telling a better story.
Benjamin Sullivan is a manager at Palisades Hudson Financial Group, where he helps the firm’s high-net-worth clients with their personal financial planning, investment and tax planning needs. He is a certified financial planner certificant, an IRS enrolled agent, and a member of the New York chapter of the Financial Planning Association.