Employee Stock – Never Put All Your Eggs in One Basket

“Never keep all your eggs in one basket” is an age-old adage and a great rule of thumb for investing.  As a matter of fact it’s a pretty good motto for life in general and there are countless examples.  So why do people forget to diversify when they utilize employee stock purchase plans?  Employee purchase plans can be awesome and should almost always be utilized to the max when they offer stock purchase at a discount to market price.  But that doesn’t mean you have to keep it all, so why do we?

First let’s take another look at the benefits of not putting all the proverbial eggs in the same basket.  When you remember to diversify and spread out the things that are important to you, you protect yourself from risk.  By diversifying your assets or prospects, you minimize the negative effect that an adverse event in any given area of your life can have on you.  For example I’ll use an analogy unrelated to investing – looking for a job.   If you set up interviews for five prospective opportunities, one rejection is not the end of the world.  However, if you only set up one interview that same rejection can be devastating.

If you think losing a prospective opportunity can be rough, just think about losing most of what you have worked for over the past 5-35 years.  Now think of what it could be like to lose all that and lose your job at the same time.  Of course it sounds severe, but this is a realistic phenomenon experienced by employees of companies such as K-Mart and Enron, when they lost not just one but two major assets due to the failure of their employer.

There are less severe instances where employees have suffered large losses due to changes in the price of their employee stock.  These examples come up frequently, and of course the period from 2007-2009 was fraught with cases of employees losing half or almost all of their savings only to be laid off around the same time.  Even people who are still working with nice job security can feel the effects of having their employee stock drop 15% in a day on bad news if they have a lot of savings tied up in it.  And if the stock of your employer is dropping like a rock, bad news or not, you might feel less than secure about your job, as well.  Just recently employees of the technology company Oracle experienced a drop like this when shares traded down over 16% at times on December 21st after a disappointing earnings report.

So why does this keep happening to people?  The reasons I’ll address are generally psychological, seemingly logical but still irrational, and driven by human nature.  Often intelligence has little or no bearing on occurrence of the thought processes leading to over-utilization of employee stock.  And while the reasons I’ll discuss below aren’t the only ones they can all lead an intelligent person to completely overlook the risk they’re exposed to.*

1.  Employee Bias – It’s every good employee’s job to know their company’s value proposition.  Especially in a large corporation everyone from cashiers to sales people is expected to be able to recite why his or her company is better than their competitors, how long it has been around, and why it will be around for all time as a leader in its industry.  Good employees also work hard to make their company that much better so it only makes sense to tie the future value of their savings to the fate of the company they pour their blood sweat and tears into.  Note: this is the polar opposite of diversification.  If I follow this philosophy I would be putting all my eggs in one basket because I have great reason to believe in that basket.  Now, not only is my income dependent on the success of my company, so is the value of my savings.  The disappearance or bad performance of one can directly cause the same result in the other.

2.  Familiarity or expertise  – If I sell high tech widgets for ABC company I have every reason to know as much about high tech widgets as I possibly can.  Therefore I am an expert in high tech widgets and know about what the high tech widget industry has coming down the pipeline for the near future.  Since I know the widget market as well as I do and expect it to grow rapidly it makes perfect sense that I should keep holding my employee stock indefinitely.

3.  Local bias – Using the previous example lets say the high tech widget industry is experiencing a downturn, and I know it.  However, widgets coming out of my area are still selling at normal levels and I expect it to continue because other companies around me seem to be doing better than their competitors in other parts of the country.  Since my area seems to be isolated from the downturn I feel strong about holding on to my company stock.

4.  Pavlov investing – John used to work at another widget company and held his company stock the entire time he was there.  When he left he had gained 150% on his company stock after 8 years (over his average price, after employee discount).  Therefore he rationalizes that he can expect a similar result with his new widget company that seems to be just as great as the last.  This programmed response to past stimuli is common in investing and can also be the most dangerous way of thinking about an investment.  Past performance does not predict future results, and the market factors that drove the previous stock price may have changed or even ceased to exist.

By holding a large percentage of your wealth in your employer’s stock, your risk related to that company is substantial.  It is likely greater than the risk you have in your 401k, your mutual fund accounts, or even your house.  Your savings should never be heavy in one stock because of the effect an adverse event for that stock can have on your savings.  If you put that stock in the same boat as your livelihood your one ship fleet can sink pretty quickly.

So, what should I do with my employee stock purchase plan?  There are very few cases where we wouldn’t recommend participating in an employee stock plan, and those would usually be in plans that don’t offer a discount.  If you have the opportunity to buy stock at a 15- 25% discount to the market price it is usually a great opportunity.  Except in the case of restricted stock you have the right to sell the stock when you please, which can give you a distinct advantage towards making a profit given your discounted purchase price.

You can consider selling immediately in hopes of a profit close to the amount of your discount, and many people do.  As an alternative to that you can always hold some and just sell off a certain amount each quarter.  If you work for a great company and want to hold some of their stock I recommend it.  But, I recommend that you set an amount that represents a certain percentage of your net wealth and sell any stock above that percentage.  For some people this may be five percent, for some younger and more aggressive it may be 15%.  The idea here is to limit your exposure to that one company.  If you already depend on them for your salary then having 15% of your wealth also tied up with them could be pretty aggressive.

What can you do with the money you receive from selling employee stock?  It’s your money so you can do what you want with it, but I recommend saving it in some way.  While I have some ideas for this it isn’t appropriate to recommend them in a public forum.  So, that decision should be made with the help of your financial consultant with regards to your current financial situation, goals and objectives.

If you would like to discuss anything from this article please feel free to call us, and we would be happy to talk about it.  In conclusion, always remember it is much harder to sink a fleet of ships than one large tanker.  If you ever find yourself on that lonely tanker it may be a good time to ask yourself where the rest of your armada is.

* Source: Are Empowerment and Education Enough? Underdiversification in 401(k) Plans. http://www.econ2.jhu.edu/seminars/elyLectures/2006/empowerment_and_education.pdf