Financial Vulnerability of Small Business Owners

By Gutter, Michael S.; Saleem, Tabassum | Financial Services Review, Summer 2005 | Go to article overview

Financial Vulnerability of Small Business Owners


Gutter, Michael S., Saleem, Tabassum, Financial Services Review


Abstract

This study examines the financial vulnerability of small business owners using data from the 2001 Survey of Consumer Finances. Financial vulnerability is determined by the extent to which income and wealth are derived from the same source. The findings suggest that business owners face unique financial vulnerability because of their reliance on the business as both a source of income and wealth. Business owners may have insufficient diversification when relying on the business as an asset to fund retirement. Among business owners, farmers are the most vulnerable; their proportions of total income and total portfolio attributable to the business are higher than other business types. © 2005 Academy of Financial Services. All rights reserved.

JEL classification: D12; D14

Keywords: Financial vulnerability; Small business owners; Survey of consumer finances; Risk tolerance; Resource allocation

1. Introduction

Household financial security, its ability to meet ongoing consumption needs and prepare for future objectives, depends on the stability of financial resources. The stability of income and wealth allow a household to maintain a level of living. A loss of either one can greatly undermine household financial security. If these two are tied together, the vulnerability is even more pronounced. Further, the stronger the relationship is between the two, the greater the risk.

Employees of publicly traded companies who own stock in their employer face this possibility. If the firm does poorly, their income may suffer from loss of bonus or simply from salary cuts. If the firm is doing poorly the value of the stock may also decrease. To insulate a portfolio from risk it is necessary to allocate the wealth to various assets whose returns are not excessively correlated; this is known as diversification. A well-diversified portfolio is one that achieves the goal of reducing the level of the idiosyncratic risk of the portfolio to a negligible amount. However, systematic risk cannot be fully diversified away and as such is justification for a greater expected return.

Small business ownership should be viewed as one element of a household's income and wealth portfolio. As such the small business owner has a greater vulnerability because the business is likely an important income source and portfolio component. In other words, if a business is doing poorly, income from the business may not be stable. If this continues the business might fold. If a business owner only has the business in the portfolio, then there is no other component offsetting any potential losses the business may suffer. Thus, the overall long-term return of the portfolio may suffer. A household may still have debt on the business or at the very least may lose asset value. The business failure risk for the small business owner is not as easily diversifiable. Further, the business owner is not as mobile in the labor force as others are.

The concept of diversification is of particular importance to small business owners. The ownership of the business introduces its own idiosyncratic risk into the overall portfolio. This risk extends to both wealth and income flows. If there is no management of this risk, then the overall portfolio is not properly diversified. This does not guarantee that the households will face a financial crisis; however, it clearly leaves them vulnerable to one.

The vulnerability of small business owners has important implications for their financial security in retirement. This is because households may plan to sell the business or collect income leaving it as a going concern; business failure can be catastrophic if business owners do not have other assets accumulating for retirement. Thus, an important question this study asks is whether business owners diversify their financial portfolios and income sources as one means of addressing the potential greater risk of business ownership. …

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