If your compensation at work includes stock in the company that employs you, you may end up with too much of a seemingly good thing.
The simple rule is to limit your portfolio's exposure to the stock of the company where you work. Generally, the income that funds your lifestyle comes primarily from the wages your employer pays you. Your livelihood is directly tied to both your future with the company and the future of the company as a whole. If you hold company stock as well, you are doubly invested in its future.
There's a reason that diversification is a fundamental principle of investing. It is never wise to pin the entirety of your financial health on the success or failure of one enterprise, or even one industry. While it may feel safest to stick to what you know, the downfalls of companies such as Enron and WorldCom illustrate how risky putting all your financial eggs in the same basket can be.
Company-specific risk, foreseeable and unforeseeable, stalks even well-established and profitable firms. Besides the risk of fraud and bankruptcy, as in the examples above, a hostile takeover, a new CEO or a dramatic shift in company culture can threaten solid and profitable businesses. Perhaps your company cannot shift nimbly enough in response to a changing marketplace; perhaps one or more leadership mistakes put its future in jeopardy.
While you should try to diversify your investment portfolio away from the risk factors specific to your company, you should also diversify away from risk factors specific to your company's wider industry. Limiting your exposure to your employer's stock is of minimal help if the rest of your portfolio still leans heavily toward the industry because you are familiar or comfortable with it.
For example, a hedge fund manager's income tracks very closely with market activity and the health of his fund. There are good reasons for him to be invested in his own fund; he may be required to be, or he may wish to strengthen his sales pitch by demonstrating his own faith in the fund. However, if he's wise, his portfolio will otherwise involve less risk than one might expect for someone of his age and income level. Since the health of the global economy so directly impacts his regular income, he would be smart not to neglect more steady investments that depend less on such fluctuations, such as real estate or fixed income.
In the abstract, many investors understand why diversification is important. Yet it is easy to feel that you know the inner workings of your company better than the market can, making company stock worth the risk. While this may be true, situations in which you actually know better than the market are where you must be the most wary of trading on "material nonpublic information" - that is, engaging in insider trading, which is illegal. While executives and board members have many formal regulations, the Securities and Exchange Commission can pursue action against anyone who benefits from trading on such nonpublic information. And if the information is publicly available, then it is almost certainly already incorporated into the stock's current price.
What can you do, then, to mitigate the risk of a concentrated position in your employer's stock?
Many employees receive their stock as part of a 401(k) plan's "company match." While every plan is different, many require you to hold the shares you receive by corporate matching. It is important to understand your plan's rules. If you are allowed to diversify your position in your employer's stock, do so frequently and maintain as small a position as you are allowed. Since it is a tax-deferred account, you won't pay taxes on the sale transaction, and reallocating within the account will keep you from compounding your risk.
Other shares come to employees through different vehicles. Stock options allow employees to buy shares after a set time (called the "vesting period"). The timing of exercising options can be tricky, and can leave you with a large holding to deal with. Restricted shares are direct grants of company stock, but such shares can only be sold after a set time. Performance shares only vest if the company hits certain benchmarks, often a predetermined level of profits or margin, over a set period.
However you receive your shares, once you have the right to do with them as you like, you and your financial adviser should develop a tax-planning strategy and sell the shares in accordance with your plan. This process may spread over multiple years, to avoid tax bracket creep. Once you have sold your shares, you can reinvest and build a properly diversified portfolio.
It is tempting to fall victim to investment fallacies with employer stock, even once you are vested. You may have mentally anchored the stock to a price that no longer reflects your company's value; this could lead you to wait for your shares to regain a price that they are unlikely to achieve.
Even if the stock hits that price again, you might forgo the opportunity for a better return on your investment elsewhere in the meantime by holding on too long. We tend to feel that future events are more certain when they would benefit us - what behavioral finance experts call an "optimism bias" - which can tempt us to hold shares even after we have the ability to sell them.
It is important to carefully evaluate whether such shares are worth the opportunity cost, as well as the risk of overconcentration. While diversification cannot guarantee a profit or protect completely against loss, it is still a smart long-term strategy, regardless of your company's current earnings.
Should you always immediately liquidate all shares of your employer's stock as soon as they are freely transferable? Not necessarily. The investor biases for holding employer stock can cut both ways. Maybe you really do understand the company better than the broad market. Perhaps the stock price is unfairly beaten down.
The core concept is to manage risk. Therefore, if you believe that there is high appreciation potential in your company's stock, it may make sense to hold on to a portion of it, while limiting the risk. The appropriate maximum exposure to your employer's stock could be different for different people. For instance, a 30-year-old software engineer who can easily get another well-paying job is in a different position than a 55-year-old administrative assistant preparing for retirement. Understanding how much company-specific risk you are willing to tolerate will help you set a maximum percentage of your total portfolio that should be allocated to company stock. A 5 to 10 percent maximum is a reasonable starting place.
Some corporate executives, especially those who have reached a high level in the organization, may be required to hold a larger amount of their employer's stock. As with the hedge fund manager in our earlier example, this is to ensure that those managing the company's fortunes have a personal stake in the venture's success. Yet it can leave such workers overexposed if they don't manage their positions intelligently.
Are you stuck if you are required to hold on to your employer-issued stock? Not necessarily. You can still mitigate the risk of concentrated holdings. Hedging is one option, though complex rules govern this practice. You cannot hedge the same stock outright, so consider looking for a stock that will perform similarly, such as a competitor in the industry.
It is also wise to build your portfolio around the required-to-be-held stock position. It's a fixed number, so design a strategy that allows for it. Say, for example, that you work for Apple and receive a substantial part of your compensation in company stock. You could hire a separately managed account (SMA) manager, who would effectively create the equivalent of a personally directed mutual fund. Because the account is personal to you, it will cost more than a mutual fund would. Your manager, however, will be able to build an S&P 500 Index model without Apple. This portfolio will obviously not match the S&P 500 exactly, since the chunk of it in Apple stock will be disproportionate; the resulting difference in performance is called "tracking error." However, an SMA will allow your portfolio as a whole to more closely mirror the market, instead of suffering undue effects based on Apple's fortunes.
It also makes sense to weight your portfolio toward stocks in sectors and industries with different risk drivers than those affecting your company. Overall, risk drivers are the factors that drive a company's performance. Common risk drivers include the local economy, the global economy, commodity prices, interest rates, technological advances and innovation, and regulation or legislation. Involving your financial adviser can be helpful when evaluating such measures, as it is sometimes hard for a layperson to see where risk drivers overlap between seemingly divergent enterprises.
Another strategy to consider when evaluating your employer stock is net unrealized appreciation (NUA). It would work like this: You receive restricted stock in 2012 worth $10 per share. You can't liquidate the holding because it is restricted, and it is unvested, meaning if you leave the company, you won't take all (or even necessarily part) of the value with you.
However, if you plan to stay at the company and you think the stock will substantially increase in value, you can pay tax on the stock now. This is a risk; if you leave the company, you may have paid tax on assets you can't keep. However, this practice also can result in a nice reward. As soon as you pay the tax, your stock's cost basis - now $10 in this example - is set, and the clock starts on your capital gains. The $10 in this example is taxed at ordinary income rates - assume 35 percent.
If you are right about the stock's appreciation, this can eventually translate to large tax savings. By the time you're vested and the stock is unrestricted, say the stock price has reached $100. Assuming that you have held the stock for at least a year, the $90 of appreciation will be taxed at the long-term capital gains rate, which is much lower than the ordinary income rate that usually would apply. At current tax rates, you would pay $17 ($3.50 at time of grant and $13.50 at the sale) per share instead of $35 per share, making the strategy well worthwhile in this example.
Up to this point, we have focused on people with exposure to stock in publicly traded companies. Does the same advice apply to those who work in companies where the shares are privately held? Again, specifics matter most. There may be a significant upside to holding shares of young, fast-growing privately held enterprises (think early investors in Facebook or, before that, Microsoft). Since these shares do not trade on established exchanges, employees typically have to resort to transactions in a limited, nonpublic secondary market. Buyers of shares in these transactions typically demand a steep discount from the shares' intrinsic value. Employees may benefit from holding on to private shares if an IPO, merger or acquisition is on the horizon.
Whatever strategies you decide to use, remember that holding large amounts of employer stock is inherently doubling down on your risk. There are legitimate reasons that it can be appealing to own company stock, but it's easy to overinvest in something that feels safe and familiar. When investing, it is important to do what you can to prevent any future financial setback for your employer from unraveling your entire financial safety net.
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