The Harbour Pilot

Step back from your focus on the business you are developing, for a moment. It is pretty important to keep your business risk and investment in a perspective of who you are, and where you are headed. A lot of that may be wrapped up in your business, but there are other investments you have made elsewhere (or may be planning to make).

Let’s consider an investment portfolio. When you meet with an advisor, there is an approach that many take now (in some areas it is mandated by a code of ethics) called the Know Your Client rule. Fundamentally, it is an attempt to shield the advisor or broker from accusations of misdealing by the client. Designed to ensure that your advice is given with an understanding of your client is presumed to prevent misunderstandings, and a bad advisor-client fit.

The advisor asks the client to fill out a form that sets out for the advisor what the client’s interests and wealth profile are. There are usually also areas for such items as family status and life cycle, and employment/profession, income and so on. Why is this either helpful or useful.

1: The advisor wants to know how knowledgeable the client is in making investments in publicly traded securities and financial markets or transactions. Some one who is either trained or experienced in this field will know terminology and concepts that a less knowledgeable client might not. Further, a knowledgeable client would understand the risks of an investment that might not be apparent to others – such as trading on margin, or engaging in currency speculation contracts.

2. The advisor is going to want to k now what your net worth is, and what portion you intend to hold in your trading portfolio. The reason for this is to teach the advisor what scope of exposure you might have. If you have a net worth of $500,000, and your portfolio in only $50,000, then 10% is significant, but even the total loss of the portfolio is not life-shattering. On the other hand, $50,000 on a net worth of $80,000 is more than 60%, and would leave the client painfully close to bankruptcy. Knowing that the advisor can steer the client away from risk that could be catastrophic.

3. The advisor is going to want to know what your income and expense position is, and what your disposable cash flow is likely to be on a monthly basis. The reason for this is to determine whether there are likely to be requirements that the portfolio might have to meet for current life style expenses. This in turn needs to be accommodated in the management of portfolio by keeping a larger percentage in liquid holdings.

4. The advisor is going to want to know what your views are on risk. Are you a risk embracer, or are you risk-averse. What about your spouse (if any). The need here is to permit the advisor to assess the quality of your judgement in any given decision. Does the advisor need to balance your tendency by clearly presenting the opposing viewpoint. It also might suggest what kinds of investment proposals are more likely to find favour with you. An advisor, after all, is in part a salesman - hopefully, an ethical one.

5. The advisor is going to want to know where you stand in your life cycle. Broadly speaking, are you planning to remain in the workforce for the next 20 years, or are you contemplating retirement. Have you started a family, or are you intending to? If yes, are you housing needs likely to change, and will funds be needed to provide a down-payment on a house. Have you started to make provision for their educational expenses?

6. The advisor is going to ask what your goals are for the portfolio. Are you looking for a certain amount of dependable cash income from investments regularly, or are you more interested in growing a nest egg.

6. After these questions, the advisor will attempt to build a portfolio proposal that will match your situation One of the first things the advisor should do is to establish a comprehensive outline of your entire net worth – all of it. This means that investments in real estate, pension plans, education, personal belongings, automobiles, art, furnishings, and collections all need to be considered. The portfolio which is the advisor’s immediate responsibility is only one component of the whole. Good and appropriate advice needs to reflect the entire picture.

Now some of us are familiar with this process. All independent entrepreneurs need to undertake the same process as well, with themselves, It is challenging to wear both the client and the advisor’s hats, but it is worth the effort. In this case, the business project is the portfolio, and it is the surrounding issues that need to be assessed.

Let’s consider a case. Kevin, 31 years old, has a small auto mechanic business that he has developed over the past six months on a part-time basis, while holding down a job that earns him some $35,000 after tax. . He owns a house near the outskirts of a small city that has a block outbuilding that he has been using as a garage. The property is zoned as mixed use residential and commercial. Purchased originally for $225,000, it carries a mortgage of some $175,000, which at an interest rate of 6.5% six-month renewable costs him some $1,500.00 monthly including property taxes. There is a net equity in the property of about $50,000. Current fair market value is thought to be some $245,000. Kevin has a pension plan of some $30,000 currently invested in some exchange indexed mutual funds, and some government bonds with a face value of $10,000. Kevin has tools for the business that cost him about $15,000, but have a realizable value of about $8,000. Household furnishings and personal property total an estimated $10,000, Kevin invested about $15,000 and two years in a college program in auto repair. Kevin is a rock-climber and outdoorsman, and plays in a brass jazz band occasionally. Kevin’s other living expenses add about a further $1,500 per month. Revenues from the part-time business have totaled some $24,000 gross sales, with profit after materials of some $10,000, for about 20 hours per week. There are no other employees.

Kevin has a net worth of some $95,000, It is split as being 55% in real estate, with an additional unrealized gain of some $20,000. He has 15% tied up in his pension after tax consequences, and some 11% in low risk debt investments. The only liquid asset he has are the government bonds, and these must be preserved as an emergency reserve.

His risk profiles are exposure to real estate, which has the systematic risks of the real estate market, but there is a cushion against market reverses of nearly 10% on the acquisition value. This is a covered risk position. The pension investments are in an equity position, but there is relatively little systemic risk; further the indexed funds by their nature almost eliminate specific risk by broadly diversifying the investment across the market. There is some systematic risk of a market correction, but the economy is strong and buoyant. This is a relatively low risk position as well, and its lack of liquidity carries the profile of a long-term position.

Kevin himself is single, quite young, and has established himself fairly strongly for his stage of life. Further he appears to be aggressive, established and both a risk taker, and a risk seeker. There is little in his profile that would warn against taking further guarded risks.

The pursuit of his business, converting it from a part-time undertaking to a full-time venture is appropriate. The change will cost some $3,000 per month after tax. This suggests that the business will have to replace that much cash flow at minimum, and it must do it immediately since the emergency reserve is only good for perhaps two months.

This analysis immediately provides some three insights for strategic efforts for the business. The first is extreme caution over the first two months of business conversion. The second is that marketing efforts are key to expanding the revenue level to some 3.5 times current levels. This is so because with a 41% profit level before labour and admin, revenue must climb to nearly $85,000 to break even on a cash flow basis. Lastly, the need to consider adding a part-time employee is clear since Kevin is unlikely to be able to sustain both a 70 hour work week, and do the marketing, purchasing and accounting work for the business.

Risk awareness – take a portfolio approach to where your risks lie before you take them on – it can avert mistakes and keep your focus on where it really matters.