Regardless of the approach taken, today’s family office needs to manage risk by creating diversity within their portfolio which would otherwise be provided by a third party manager.
One of the questions we are asked by investors relates to the risk in purchasing an interest in or financing an exciting early stage or start up venture. Minimizing risk is tricky if you choose to invest anything. Most family offices and wealthy individuals know the relationship between greater risks and higher returns. Diversification is one method that can balance risk in a portfolio.
Alternative investment diversification can be created through a number of methods. Some investors attempt this themselves but increasingly seek the services of a professional independent advisor to assist them.
Diversification is the division of your investment portfolio among varied assets. It can assist risk reduction because different investments rise, plateau or reduce independently. In a well structured portfolio of direct investments, diversified asset combinations typically cancel out each others fluctuation, therefore reducing risk.
Family Offices can diversify within a specific asset category such as medical technology or manufacturing. To do this you could acquire interests in companies in different geographic locations. Or you can diversify your portfolio across different asset categories (eCommerce, medical technology, defense technology or automotive development for example). Or you can diversify in ventures that are spread out in timing on the development “curve”.
Clearly for your diversification strategy to be effective, improved performance while reducing risks is ideal. Typically we view two broad risk types when analysing alternative investments. These are known as unsystematic risk and systematic risk. Part of our job is to assist our inner circle clients identify and subsequently reduce these risks.
Unsystematic risk is sometimes referred to as diversifiable risk and is specific to a particular investment. It may be that an opportunity shows weakness in one or more particular areas after we have run our due diligence. Our obvious goal is to mitigate those factors and provide a sensible balance of risk versus reward profile. We cannot always remove the risk, we can however reduce it and spread the likelihood of such risks at any one time or alter the price of the risk on your behalf.
Systematic risk effects everyone at the same time and accounts for most risk most of the time. Examples such as 9/11, the collapse of the financial markets in 2008 and impending war in the Middle East affected economies, not just a business sector or industry. Investors cannot eliminate such risk as it is beyond their control, as such it is un-diversifiable risk.
‘Diversification across ‘asset classes’ or different investment sectors and markets helps reduce your risk by cushioning market tremors and removing most unsystematic risk from your portfolio. You should get rewarded appropriately for taking market risk. We can reduce portfolio risk by excluding un-systematic risk that investors are not rewarded for.
Diversification averages out asset returns within your alternative investment portfolio, it smooths potential ups and downs and it provides good protection against business risk, financial risk and volatility.