It turns out we haven’t evolved much after all. Research shows we view risk much like our pre-historic ancestors.
We analyze it two ways – logically and emotionally. Most of the time, we instantly use the second way – our feelings.
It’s just how our brain works. Bells and whistles go off quickly when we sense risk. Turning them off is much more difficult because it’s not natural.
So humans are good at assessing short-term risk; we’re not so good at the long-term risks we’re more likely to face in our modern world.
The myth about owning a business
There’s a myth about owning a business. People think entrepreneurs take a lot of risk. In reality, the most successful business owners are excellent risk managers.
They know they can’t predict the future. So they don’t try. They create their own future.
There are many ways to manage risk. Many business owners overlook one that’s also a key trick of successful investors: diversify, diversify, diversify.
Diversify your supplier base
What would happen if your biggest supplier suddenly ceased operations – temporarily or permanently? If your business would be seriously harmed by interruptions in their business, you need to diversify.
In general, if more than 10% of your purchases are made with one supplier, you should give diversification serious thought. It would be better if it were 5%; 20% is a real danger area.
Of course, your suppliers may compensate you for the risk of concentrating your purchases. You may be able to negotiate a lower price.
On the other hand, inertia often sets in as we deal with suppliers. We don’t review prices as often as we should. So you may find your supplier offers better prices once it’s obvious you’re evaluating alternatives.
Our focus on price here isn’t meant to overemphasize it. There are many factors upon which you base your decisions about suppliers.
We’ve discussed price because diversification, as a form of risk management, is like insurance. Any increased price you may pay as a result of diversification can be viewed as your premium.
Diversify your product or service offerings
Small businesses don’t tend to have a lot of diversification in their product and service offerings. You definitely should offer more than one product or service so you make more money, more dependably.
Don’t just think categories. People tend to think of product categories when talking about diversification. But you might even be able to diversify within categories.
For example, move from offering one product or service in a category to a good – better – best offering. Not only will this increase your sales, it will help smooth out your income.
Also, do you make money in lump sums or as an annuity? Ideally, you make money both ways.
You sell a higher priced product or service where you make a lump sum of profit. Then you follow it up with ongoing product purchases or services, which gives you your annuity.
In some cases, you may find you don’t really need to make any money on the lump sum purchase. It’s your loss leader – your low-margin product or service. The annuity product or service brings high margins steadily. So, as your sales of loss leaders increases, so does your annuity income.
Diversify your customer base
As with your suppliers, you don’t want your sales to be too concentrated. It’s best if no more than 5% to 10% come from any one customer.
If yours is greater than that, don’t despair. You’ll just want to work extra hard to land another significant customer or a whole lot of small ones. And don’t let customer service to your existing customers falter. It’s a tough balancing act, to be sure, but it’s not impossible.
Also, look at your diversification in other ways as well. Is there an industry that is over-represented in your customer base? It may be a natural part of your business, but beware of the risks. If the industry experiences tough times, so will you.
The same goes for geographic diversification. Are you dependent on the economy of a specific region for your success? Of course, some businesses can’t diversify geographically. Thanks to the Internet, however, it’s easier than ever to sell to people all over the world!
