As I begin to write this article, I’m sitting on my couch at 6:21 a.m. watching Bloomberg TV on mute as the top news and market indicators dance across the screen. It’s the same old thing: political trouble, public company takeovers, red and green boxes showing advances and declines in the world’s major markets, and talking heads trying to be interesting.
It never ceases to amaze me how the media can manage one’s perceptions by selecting what information to broadcast and what to bury. This biased information is then disseminated to the financial advisory world as countless financial advisors are trying to add value to client relationships by somehow predicting future market moves—something that has never been successfully done no matter how much marketing to the contrary.
As the stock market flirts with all-time highs and the pain of the Great Recession is but a cloudy memory, we are once again seduced by double digit returns—deluded by the idea that a 20% gain last year will mean a 20% gain this year in our investment accounts.
And that may happen, but we also know that the party will end and the hangover will ensue. Past experience demonstrates the predictability of that fact. The way to avoid a hangover is to drink in moderation in the first place, or not at all. Speculative investing tends to follow the same rules of cause and effect—the drunker you get, the worse the hangover.
How do we then avoid this unpleasant state of affairs? We accomplish this through the application of moderation in our investment experience — correct diversification. “Correct” means “to set or make true, accurate or right; remove the errors or faults from” and “diversification” means “the act or practice of… investing in a variety of securities… so that a failure in or an economic slump affecting one of them will not be disastrous.” So correct diversification occurs when one spreads the risk of loss over different kinds of investments and does it actually, and not apparently, without error.
As a private practice professional, diversification takes on new dimensions and applications when we address the household as a business. As you will recall, your household is the entity that holds all of your assets, including all or a portion of your professional practice. As such, ALL assets must be taken into account when determining the correctness of the diversification. This is a subject called risk management and is a technology that is in full use in publicly traded companies: the mitigation of risk by diversifying allocations of capital into different business activities.
Do we consider the professional services firm as an asset in the diversification decision? Well, since it is usually the asset with the largest market value in the household, it would be necessary if diversification is to be accomplished without fault or error. Unfortunately, most financial advisors disregard this asset when managing other securities in the household, resulting in a diversification strategy with the error of unnecessary exposure to loss. This stands to reason, since most investment advisors are managing “the account” and not “the household.”
How much risk is intrinsic to the professional practice? The best way to quantify risk is to compare it to public markets with a metric known as the price to earnings ratio. This ratio compares the stock price to the earnings per share. In other words, what price an investor would pay per share of stock for the earnings derived by the company over the last year. For example, the S&P 500, an index of the 500 largest companies in the US, is trading around 18 times earnings—$18 price for a dollar of earnings. This is the value on which all of the collective buyers and sellers of those companies agree at this moment in time. Comparatively, what is the market value of your professional practice? In most industries, a typical practice will sell for about 2-3 times earnings: $2-3 invested for a dollar of earnings.
The difference between the valuations of 500 large US companies (collectively) and your practice is enormous. Investors will pay the price for each dollar of earnings based on the risks they perceive in the marketplace. Since your private practice will sell for, let’s say, 2.5x earnings and the S&P 500 will sell for 18x earnings, your small business is at least 7 TIMES riskier to own than an S&P 500 index fund!
Now, if you have a $1 million practice, it will be worth around $700,000, plus or minus. If you have $300,000 in other assets outside the practice invested in speculative accounts that hold stock market investments, then where do you stand with regard to the overall risk profile in your household? That’s right! Extreme speculation with no safe harbor. And if you have consumer debt such as cars and a mortgage, then you are really exposed! The Household Risk Index® is the Econometry® analytic that measures this condition and is one of the central measurements in our Econologics Road Map®. We measure this so we can bring the risk DOWN!
This requires a re-appraisal of the risk profile in the household including ALL assets. If done correctly, you will find recommendations that are more conservative in nature, and yes, BORING! The question is a simple one: what is wrong with diversifying away from speculative assets over which you have no control (stock mutual funds) into assets that may be guaranteed to retain value, regardless of economic disasters? The answer is also simple: nothing, it is only prudent.
Remember, you will make your fortune in your practice, not in the latest run-up in the investment markets. A financial advisor can only assist you in retaining the value you created in your business by helping you turn profits into wealth by consistently saving and protecting what you have saved.
Stop chasing investment returns. The 20% you made last year may happen again, but the party will end and markets will correct back to median values, along with your account balance. The recent consistent market highs is the indicator that rough times are ahead.
Private Practice Millionaires know how to correctly diversify and know not to follow the crowd or fall prey to marketing hype. They are rock stars. Just like you.
Live Your ART!™