The employees of public companies have their personal wealth highly concentrated in company stock, due to the combination of their stock option grants, employee stock purchase plan (ESPP) shares, open market stock purchases, restricted stock, and stock in 401(k) plans. In this article, we will evaluate the risk this circumstance presents and then decide whether and how to diversify.
Embrace the ownership culture. Your company wants you to think and work like an owner, with your equity compensation acting both as motivator and reward. Various forms of stock pay align worker and shareholder financial interests. In an effort to create this ownership culture, companies make it easy for their employees to own company stock or rely on it for personal wealth. They award stock option grants and restricted stock, along with having ESPPs that offer a discount. Additionally, many companies make company stock an investment choice in their 401(k) plans and fund the company’s matching contribution with their own stock.
Buy what you know and believe in. These benefit plans are a good deal that have helped many employees build substantial personal wealth and work towards their financial goals. You may envy and hope to emulate the employees at some hot tech company who got rich on their company stock. It’s an axiom of investing to buy stock in companies and industries you know and believe in and then hold for the long term. However, employee stock investors who have a strong emotional commitment to their company are following this maxim to the extreme.
Understand the risk. With large potential gains come risks you must understand and accept. A large, single-stock position will likely cause improper diversification by throwing off your asset allocation (i.e. putting too many eggs in one basket).
In their Nobel Prize winning work on Modern Portfolio Theory (MPT), Harry Markowitz and Bill Sharpe, showed that asset allocation determines most of a portfolio’s performance. If your company stock underperforms the market, time magnifies the impact. Your company is statistically unlikely to be an exception…A more recent study looked at the four-year performance of all companies which were members of the S&P 500 at some point between 1997 and 2012. Specifically, at the four-year performance of each company, starting on its date of inclusion in the index, or an anniversary of its inclusion, so long as it remained a member of the index. The historical data show that the median company under-performed the index by roughly 2.5% over one-year, 5% over two-years, and by over 10% over four-years.
Get informed: Learn your company ownership percentages. You probably know your weight, cholesterol level, blood pressure, and family health history. It’s time you understand the same type of factors that impact your financial health. Below is a simple chart you can use to summarize the percentage of your net worth that is currently in company stock and options.
Percentage of My Personal Wealth in Company Stock
Total $ Amount
% In Company Stock
Brokerage and Taxable (B&T) Accounts (include ESPP shares)
In-The-Money Vested Options, plus B&T Accounts
Restricted and other Stock Certificates, plus B&T Accounts and Vested Options
Other Retirement Savings, plus 401(k) (include spouse)
Compared to the various legislative efforts that have been considered, over the years, to place statutory caps on company stock ownership in 401(k)s, employees may find this type of ownership percentage table more consistent with the freedom of choice that employee-investors want and the disclosure approach that underlies our securities laws. You can add more rows to this chart that take account of unvested in-the-money options, anticipated future grants, and other company plans (e.g. deferred compensation) whose value is linked to company stock performance.
ESPP payroll contributions currently waiting for stock purchases can fit into the existing categories or be put in their own row. You can also assign long and short-term financial goals for your different wealth sources, deciding that for some of these milestones you want company stock to be more or less of their total.
Feel the impact of price jumps and dives. Just as you should know your risk of having a heart attack [If you don’t, see the National Institute of Health calculator at http://cvdrisk.nhlbi.nih.gov/] and take appropriate steps to reduce it, you should know the risks of owning company stock. Using this health analogy, company stock can be either vitamins or fatty deposits in your bloodstream.
A simple mathematical correlation explains the effect of price swings. Multiply a typical percentage increase or decrease in your company stock price by the percentage of your personal wealth in company stock, assuming there are no other changes in your other investments. For example, if the stock price moves 80% and company stock is 20% of your wealth, it changes by 16% (.80 x .20 = .16 x 100 = 16%).
Relationship Between Company Stock Ownership and Price Changes
% Price Change
% Personal Wealth Change
See your full financial picture. You could get more sophisticated by looking at your company stock history of percentage increases and decreases (i.e. volatility), and also by analyzing how this compares to the riskiness of alternative investments. However, given the uncertainty in the stock markets and the drastic changes in many companies’ prices in the last few years, most companies’ historical performances will not prove to be a useful predictor of future behavior. You can complete your financial picture by considering your other investments in similar industries, whether they are mutual funds or individual stocks, because industry sectors can move in unison.
Decide what makes you comfortable. Ultimately, you need to decide what level of risk helps you reach your financial goals, and must understand the upside and downside of the risks you take. Most of us tend to be more risk-averse than we realize, which we often realize too late. From my observations, once stockholders have been through a market upheaval, many of them would rather avoid the impact of a stock price drop on a concentrated position than reap the benefits of a substantial stock price rise. They often decide that the intensity of pain from a 20% fall in their net worth is much greater than the intensity of joy from a 20% rise.
At some point with your company stock, too much of a good thing can cause you to worry, lose sleep, and become too focused and frustrated about its performance. For some people, 20% of their net worth in company stock is the magic number; for others, it is larger or smaller. Financial planning tools are available (and certainly plenty of financial professionals) to help you pin down your own tolerance for risk and develop an “ideal” portfolio allocation. I have learned, however, that even the most experienced investors believe that their individual situations are unique. They will want to adjust the recommendations of an impersonal planning tool to fit their own lifestyles, market predictions, and circumstances.
Understand strategies, taxes, and company rules. If you are a regular reader of my posts, you know that I have written about the merits of various strategies for your stock options, ranging from waiting to exercise options until later in their term, to special, pre-approved selling programs adopted by executives under SEC Rule 10b5-1. You should educate yourself on the tax rules for sales.
For example, capital-loss carry-forwards from the past year’s unused losses can offset capital gains you generate from sales, making it less “taxing” to diversify. One “benefit” of potentially higher taxes which nobody talks about is that the higher rates make loss carry-forwards more valuable if they are used to offset ordinary income. New tax rules still allow capital loss write-offs against ordinary income up to $3,000. In the 32% income tax bracket, this is worth $960. In the top 37% income tax bracket, the offset is worth $1,110.*
Your company also may have blackout periods that limit the times when you can sell company stock, may impose restrictions on hedging and margin loans, and may even present stock ownership guidelines to consider.
All of these rules and strategies, when evaluated together, become difficult to understand fully, so you might want to consider consulting with a financial professional who has experience counseling optionees and has a familiarity with your stock. The financial professional should understand how to use special provisions in your stock plans, such as swaps and reloads, to your better advantage.
Diversify in retirement accounts. Should your company stock represent too large a portion of your retirement savings for your risk tolerance, examine ways to reduce overconcentration, which can quickly grow in years when your company stock performs very well. If your company makes matching contributions in stock, and especially if the plan restricts you from moving your employer-match portion, the accumulation can sneak up on you.
Employees of some of America’s best-known companies have experienced some not-so-well-known, but nevertheless spectacular, stock-price collapses. Well-publicized debacles during the last decade are familiar. Less well remembered are the declines of household names like Sears or Bristol-Myers Squibb. Even the employees of financial companies like Lehman Brothers, who might have been expected to know better, have made the mistake of betting their entire retirement future on the company stock.
If you face this high-risk circumstance, diversify your contributions in as orderly a fashion as you can, consistent with your company’s rules. Make sure to allocate your retirement-plan portfolio across multiple sections of market segments available in your plan (e.g. growth, value, large cap, small cap, international, and bonds).
Do regular check-ups. Your company wants you to see its stock plans as long-term wealth builders and to share in the company’s financial success that you help create. Employee stock ownership and financial sanity can co-exist as goals. By doing a regular financial check-up, finding your comfort zone for your ownership percentages, analyzing your company’s financial results, and rebalancing to diversify your portfolio, you can better position the value of your stock-based employee benefits.
*For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice.
The return and principal value of stocks fluctuate with changes in market conditions. Shares when sold may be worth more or less than their original cost. A diversified portfolio does not assure a profit or protect against loss in a declining market. Asset allocation, which is driven by complex mathematical models, should not be confused with the much simpler concept of diversification. All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.