Many people hold an oversized chunk of their portfolios in employer stock. While it may be performing well, there is a large body of research that has shown that holding a diversified portfolio of stocks outperforms concentrated stock holdings. You may be unwittingly giving up potential returns that could be compounding over time – potentially costing you thousands or hundreds of thousands of dollars in retirement income.
In this post, we will look at various types of company stock, why you may want to consider divesting it, and the best way to do so while overcoming your psychological objections.
Company Stock & Options
Many publicly-traded companies leverage their stock as an incentive for both executives and employees. For example, a consumer products manufacturing firm may match employee contributions to a retirement plan if they purchase the firm’s stock, or a technology company may give employees stock options each year as an incentive. It’s easy for these employees to accumulate a lot of company stock and create imbalances in their portfolios.
The most common types of employer programs include:
- Employee Stock Ownership Program (ESOP) – An employer-owner program that provides employees with an ownership interest in a company. These shares are provided as part of an employee’s compensation package.
- Employee Stock Purchase Plan (ESPP) – A tax-efficient plan that enables employees to purchase company stock at a discount through payroll deductions that build up between the offering date and the purchase date.
- Employee Stock Options (ESOs) – Employee stock options are designed to incentivize employees with performance targets, but they’re not actual financial stock options and are considered a part of their compensation package.
- Employee Retirement Plans – Employer retirement plans may permit employees to purchase company stock at a discount or match 401(k) contributions. In fact, recent studies have shown that about 40 percent of companies offer these options.
It usually makes sense for employees to take advantage of these programs. After all, you can rarely find an instant 15 percent (in the case of a stock discount) or 100 percent (in the case of a matching contribution) return in the wider market. Despite the incentive to acquire the stock, you shouldn’t feel obligated or compelled to hold the stock longer than is required to secure the financial benefits – in fact, you could be worse off by doing so.
Are You Holding Too Much?
Modern Portfolio Theory (MPT) is a Nobel Prize-winning framework developed by Harry Markowitz and Bill Sharpe that demonstrates how to build an ideal portfolio. In particular, MPT uses a technique called mean-variance optimization to build an efficient frontier of optimal portfolios that provide maximum expected return for a given level of risk. The details of this model are complex but there is a simple takeaway: It pays to diversify.
According to MPT, you should only concentrate your portfolio in company stock if you expect a very significant outperformance relative to a broadly diversified stock index like the S&P 500. Of course, that rarely happens, and the market is notoriously unpredictable. The best decision is almost always selling the company stock as soon as possible and reinvesting the proceeds a balanced portfolio or a long-term investment strategy that maximizes your expected returns given the risk.
Some experts recommend minimizing future regret rather than optimizing future returns. In this case, regret is calculated as the annual return that you would have lost compared to the ideal selling strategy. Betterment contributors Jakub W. Jurek, Ph.D,, and Celine Sun, Ph.D., CFA ran an analysis on a basket of S&P 500 stocks and calculated that the mean annualized regret was minimized by selling immediately and increased the longer that you waited to sell.
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How to Diversify Your Holdings
The best advice – as we’ve demonstrated above – is to sell your company stock holdings immediately and reinvest them in a balanced portfolio. If retirement is right around the corner, you should consider an income focused strategy to maximize your portfolio paycheck once you retire. It can be a difficult leap for many people to make this decision on a psychological level. There are also some important tax considerations to keep in mind when diversifying your holdings, especially if you hold the stock in non-retirement accounts that are subject to immediate taxation.
Let’s take a look at some common objections:
- I am loyal to my employer. If you work for a large company, selling company stock will not have a meaningful impact on its market capitalization. Many executives sell stock on a regular basis to rebalance their portfolios and you should do the same. If you work for a smaller company, you should keep in mind that your employer probably values your own financial wellbeing over their wider wellbeing.
- I know the company, so I can sell before the stock drops. We all feel a deep connection to our employer. As a result, we might also feel like we have ‘inside’ information that will impact the stock price. In reality, even top executives and CEOs can’t predict the future of their company’s stock.
- What if the stock goes up? The fear of missing out is a classic case of cognitive dissonance, or having inconsistent thoughts or beliefs, especially now that you’re aware of MPT and its recommendations. In the vast majority of cases, you’re better off selling everything right away rather than over time or not at all.
- It seems like such a big move. There’s no doubt that selling a large chunk of your net worth is a big step, but remember that you’re not losing any value, you’re simply converting value from stock to cash and then back to stock. The only costs relate to the transactions and the net benefit tends to outweigh the costs.
There is also a “putting all your eggs in one basket” aspect to investing in company stock. Being employed and receiving your regular paycheck already makes your company a huge part of your financial situation. While no one thinks it can happen to them, imagine your company hitting hard times and cutting their workforce. Not only could you end up out of a job, your net worth can dropped significantly if the stock price declines.
Bear Stearns and Enron are two perfect examples of this unfortunate situation. It was rumored that Bear Stearns encouraged company stock ownership and everyone participating in the company’s success. This all seemed great until the very end. In a matter of just a few days, these employees lost their jobs and potentially their entire life savings.
Taxation is another key reason for avoiding the process of divesting company stock. If you’re holding the stock in a retirement account, you can probably reallocate the assets without any tax penalties. But if you’re holding the stock in a taxable account, you may be responsible for capital gains on the difference between the cost basis and the current market value. It’s often best to discuss these issues with an accountant to develop an optimal strategy.
The Bottom Line
It’s common for employees to hold oversized positions of company stock in their portfolios, but this is almost always not the ideal allocation for maximum risk-adjusted returns. The best option to diversify is to immediately sell the company stock and reallocate it across your portfolio. Since this can be psychologically difficult, you may also want to consider selling a large chunk now and selling the remainder over the course of a year.
When building a diversified portfolio, you may want to consider using covered call options to generate income. Snider Advisors provides tools and strategies to identify covered call opportunities and take advantage of them.
For more information, try our free investment courses as an introduction.
