Company Stock is Great, But Don’t Put Too Many Eggs in Your Employer’s Basket

If you’re lucky enough to have it, stock compensation is an awesome benefit! As pension plans fall away, more employees are finding themselves eligible to receive some form of company equity as part of their overall compensation package. Generally this equity comes in the form of company stock or stock options, which are subject to vesting or holding periods. You might also be eligible to purchase company shares at a discount.

If you are receiving equity compensation, it’s important to stay mindful of how much of your investment portfolio (and other assets) are dependent on the success of the company that employs you.

Mr. RFL recently vested in a significant amount of restricted shares and stock options at his current employer, so we’ve been thinking a lot about this topic. With this additional equity, we finally reached financial independence!

However, the vesting also pushed our investments in his company up to almost 14% of our investment portfolio. We like diversification, so having such a large amount invested in his employer made us uncomfortable.

And, so I set out to determine “how much equity is too much” when it comes to your employer, and to figure out what that means to us.

Diversification is the name of the game

Most investors know that diversification is an important attribute for building a resilient investment portfolio. A properly diversified investment portfolio is less risky that one that’s not.

One way to improve diversification is to avoid holding too much of any one investment in your portfolio. An individual stock (or niche asset) is much more likely to go to zero than a broad-based index fund.

Remember that equity is not your only exposure to your employer… You already depend on the company for your salary and benefits. Adding company stock only increases this exposure, which is something to consider if you’re still at the point where losing your job would be a significant financial burden.

Remember the folks at Enron? They believed in their company, too. Not only did they lose their jobs when the company went under, but many also lost a significant portion of their retirement savings.

Be careful not to put too many of your eggs in your employer’ basket.

How much company stock is too much?

In researching this question, I found the general consensus among financial experts and brokerage firms fell between using 5% to 20% of your investment portfolio as the top limit for investing in company stock (or any one stock).

Despite what the “experts” say, only you can determine the appropriate portfolio allocation for your family, including what percentage you’re willing to devote to your employer’s stock.

There is no one right answer, and it can be difficult to pick the right percentage for you. This decision is made even more challenging by the guilt employees often feel when selling company stock. 

Some of that guilt may be internal, but it can also be external. I saw a tone at the top which frowned upon employees cashing out of their stock compensation at many of my former clients.

At the end of the day, this is YOUR compensation.  If those same executives decided to give you that compensation in the form of company stock instead of cash, they have no right to tell you what to do with it. They also probably make a lot more money than you do, so may not understand the diversification risk in your portfolio just from the dollar amount.

Still can’t decide what to do?  Ask yourself these two questions…

If you’re still struggling to decide how much is too much, or feeling guilty about unloading your shares, try asking yourself the two questions below. We found this exercise to be very helpful in making our own decision.

Q1 – What percentage of your portfolio (or dollar amount) are you comfortable holding in any single stock?

This question is important in helping you determine your own risk tolerance when it comes to diversification.  Your answer will provide a good starting point for determining where to cap your investment in company holdings.

When it comes to setting a threshold, you can pick a dollar amount or percentage of your total investment portfolio.

If you believe your current employer has a strong future and there is room for the stock price to grow, you may choose to keep your allocation higher than this threshold. Only you can determine what is best for you given your own timeline and risk tolerance.

On the contrary, if you feel like there is a greater risk at your company than the general stock market, for whatever reason, it may be wise to set the threshold even lower.

Our answer to this question

In discussing this topic, Mr. RFL and I both agreed that we aren’t comfortable having any more than 5% of our portfolio invested in an individual stock. In dollars, this is $50,000 based on a $1,000,000 portfolio balance.

I’ve historically gotten antsy with individual investments above $5,000; however, I’m more risk adverse than my spouse and $5,000 is no longer a meaningful percent of our portfolio.

But for some reason, holding a much higher amount of Mr. RFL’s employer’s equity hasn’t stressed either of us out as much as it should have. That is familiarity bias kicking in. As a member of the company, you may feel more confident investing in your employer. However, unless you’re the CEO, you’re probably not privy to all the information.

Q2 – If your stock compensation automatically cashed out and you received a bonus for that amount, what would you do with the money?

For this exercise, consider the current market value of your company stock and/or options.

If you received $100,000 (or whatever your number is) as a bonus today, what would you do with that money? Assume that you don’t have any money invested in your employer when you answer this question.

If the answer isn’t, “I would buy stock in my employer,” it’s a sign that you should be holding less.

Our answer to this question

If we received this money, we would do some combo of investing in the total stock market, paying down our mortgage, and funding a Donor Advised Fund.

Notice that we would not allocate a single dollar to “buy more company stock.” This made it clear to us that we should cash out some (if not all) of our vested holdings.

So, what will we do with our company stock and options?

After performing the above analysis, we ultimately decided to cap our investments in Mr. RFL’s employer at 5% of our investment portfolio. As we’re currently above this threshold, we’ll need to take some actions to bring our current exposure down.

Our increased holdings previously reflected the desire to be a “good employee.” Wanting to outwardly show support for your employer is a normal default, but that doesn’t make it the best decision.

Performing the exercises above helped us to realize that we shouldn’t be investing that much of our portfolio in a single company, even if we think most of the risk is upside.

How (and when) should you reduce holdings?

Once you’ve decided what to do, it’s time to come up with a plan to liquidate any excess holdings.

If you only hold a single type of investment in your employer, such as stock OR options, the “how” is an easy question and you just have to determine the “when.”

However, if you have a variety of holdings and you aren’t planning to liquidate everything, like us, you’ll have to decide what to sell and what to keep.

Mr. RFL holds both vested shares in the company and in-the-money stock options.

There are pros and cons to selling each of these types. For example, options must be exercised within a fixed period and immediately upon leaving the company, but shares could be held indefinitely. Additionally, we already “earned” income and paid taxes on the shares, and any additional gains or losses would be treated under capital gains rules. Whereas we would be responsible for paying the full amount of taxes on any options exercised.

But the biggest difference between options and shares relates to risk.

In general, holding options is riskier than holding shares.

Why? Because options only have a value if the share price is above the option’s exercise/strike price. If the stock price falls below strike price, known as being “out of the money,” your options are worthless. Whereas, with shares, the stock price has to fall all the way to $0 for the shares to be worthless. Because of this, the value of options is much more volatile and reactive to changes in the stock price than shares.

Let’s look at an example in the table below. Assume that we own 200 shares of Company XYZ’s stock, which is valued today at $100/share (or $20,000). We also own 1,000 options with a strike price of $80, also worth $20,000 today.  

Here is how the value of our original investments fluctuate with changes in the stock price:

If the stock price falls by 10% (from $100 down to $90), our shares are now only worth $18,000 or 90% of the original value.  On the other hand, our options lost a whopping 50% in value, down to only $10,000. If the stock price falls, we are better off holding shares than options.

On the contrary, if the stock price increases, we’d be better off holding the options. In the example above, when the stock price increases to $120/share, the shares are now worth 120% of their original value at $24,000, but the options have doubled to $40,000!

Our next moves…

Because we plan to reduce our overall exposure significantly and are bullish on the company, we’re okay taking on the additional risk to hold options because the potential upside is huge.

We plan to liquidate all of our shares in the company, before exercising any options. Getting below $50,000 will require exercising some of the options though, so we’ll probably start with those that have highest strike price.

We haven’t finalized the timing, but plan to make our move (or moves) within the next few months.

Don’t forget about taxes!

If you’ve decided to liquidate some of your company holdings, don’t forget that the government will want their cut.

How much will depend on your situation and the structure of your stock compensation or stock purchase plan. If you don’t understand how your plan works, ask your HR representative.

Understanding what your reportable income and tax burden will be before making any moves is key in legally minimizing your tax burden. This might include tactics such as shifting the timing of these or other big transactions between years, or by maxing out itemized deductions (i.e. by contributing to a Donor Advised Fund).

Regardless, the best time to tax plan is before you’ve done anything that you can’t undo.

The winds can shift at any moment, so it’s wise not to keep all your eggs in one basket.  

How much company stock (or options) do YOU think is too much to hold?

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