COLUMN – How much can you afford to lose?
This article, while focusing on how to structure investment deals with various entrepreneurs, may be used as a template for considering other investments.
Before any investment deal is contemplated, an investor should consider the worst-case scenario: if this deal goes south, do I lose everything?
(a) Do I lose everything or a manageable amount?
(b) How can I protect myself from the worst case?
(c) Are there any protections in place?
Once you as investor have figured out those things and realize the worst case is not the end of the world (unless you plan on investing your entire life savings –– not advised), then you have conquered the major psychological hurdle of investing.
Going in-depth a bit. A manageable amount varies from investor to investor, but generally an individual investment should not make up more than ten per cent of the funds you have allocated to investing. As a part-time investor, you should also stick to investing no more than ten per cent of your net worth.
Note, net worth = total assets – total liabilities.
Unfortunately, for the individual investor, the investment offer is usually “take it or leave it”, as he/she does not have enough money to cover professional fees in order to change terms, nor does he/she have a sufficient amount of money for the investment manager to consider changing the terms (think mutual fund). Thus the small investor has to rely heavily on the strategy of diversification and making prudent choices in line with his or her risk appetite.
Fortunately for a small business, that changes as the entrepreneur is much more flexible and eager for smaller amounts of money.
Ways to limit risk:
1. Asking for collateral (via contract).
2. Mandating you are paid monthly from profits.
3. There are countless other ways to protect yourself (try Google, watch Shark Tank).
Usually for structured/registered investments there are protections already in place; for an entrepreneur deal none will be. Hence, see below.
Upside/profits. Now that you have some idea of the risk involved, what about the upside/profits?
Once again, in a structured investment (managed account) the profit is not determined by you. You get whatever the investment manager earns minus his/her fee. In this case (investing in an entrepreneur), the profit is negotiated between you and the entrepreneur.
It can either be:
A loan (debt);
Some combination of the two.
It should be noted that there are many different types of debt and equity investments.
The potential gains from a riskier investment usually are much more than the potential profit from a low-risk investment. Thus the investor is compensated for higher risk by greater potential profits. This is why so much time is placed on portfolio allocation.
Professional investors don’t wish too many low-risk investments, nor do they wish too many high-risk investments. Getting the balance is key. You may not be a professional investor, but you should still consider the varying levels of risk in your portfolio.
Next week, it is all about identifying good investments/entrepreneurs.
(Craig Harewood is the investment director at OurInterest Inc., an investment company that trades on global markets and from time to time assists small businesses and boutique investors. To learn more about OurInterest’s financial products and receive weekly financial tips, follow OurInterest on Facebook (https://www.facebook.com/OurInterestINC). For access to our quarterly newsletters, simply email firstname.lastname@example.org)
Disclaimer. These articles are intended to be general in nature and provide sufficient advice to change/promote the investment culture in Barbados. They are not meant to give specific investment advice to any one individual; and the author does not accept any liability for investment deals made, or any action taken as a result of reading these articles.