Never Invest In This Kind Of Stock

Let’s do it like this.

First we’ll talk about how 1 doesn’t always equal just 1.

Then we’ll see that $1 can sometimes only be worth $0.58, or maybe just $0.36.

We’ll wrap up with why lots of people who think they’re investing $1 (or even, say, $1.20) in a certain type of equity are really obtaining much less than a dollar’s worth of value from that investment. And we’ll cover what to do about it.

And, no, this post is not some flimsy sleight-of-hand crap or rank speculation about returns differentials.

Never Invest In This Kind of Stock
Never Invest In This Kind of Stock

This post is about some serious research largely done 10 years ago that pretty much started out with a paper published in a very important economics journal (the Journal of Law and Economics). But, for whatever reason, all the research seems to have not made its way into mainstream pop-economics and personal finance.

This post is about changing that, and about saving your portfolio from utter ruin.

Magic

First the fun. You’ve maybe seen this number identity thing before. But it’s pretty cool, so let’s take it for a spin around the ring anyhow.

Want proof that 1 can be equal to something other than just 1? Don’t believe me that 1 can be equal to 0.999…?

Do we agree that, if two starting quantities are subjected to the same mathematical operation and the ending quantities are the same, then, by math-y law, the starting quantities must be equal? (You should agree with this. Not only is it right, it’s also pretty obvious.)

Great, glad we’re agreed. We’ll use that idea to prove 1=0.999…

Take both quantities and divide by 3. You get 0.333… and 0.333…

Yes, that infinitely-trailing 0.0…01 is illusory. It has no weight, and, depending on your particular theology, might not really exist.

Which is cool and mind-bending and pretty unhelpful. But it loosens us up for something similarly cool and mind-bending but very helpful.

Black Magic

That’s this: According to some pretty extensive empirical research, employee-investors (i.e., employees of a company who own equity shares in that company’s stock) may have only about $0.50 of real economic value in that investment for every $1 that shows up on their monthly statement.

Which means, yes, those employee-investors might be in the range of 40% to 60% poorer than they think.

Which is kind of like thinking you’re running a 4-minute mile only to find out the treadmill’s not measuring your speed quite right and you’re actually chugging along like a beached manatee.

Which sucks. But which is – phew – very easy to fix.

Since this is the kind of research that tends to get under people’s skin, though, let’s chat about its particulars just a little before we get all itchy and start talking solutions.

Go back with me in time. There’s a big-ass company in Houston run by some exceptionally smart dudes. They’re revolutionizing the way energy is traded, and they’re just kee-rushing it out there. The stock’s way up and everybody’s partying like ecstasy won FDA approval for heartburn. Janitors are driving Mercs and moving in next door to Astros all-stars and dating supermodels. Life’s so good, you hardly even notice the humidity anymore.

And then it all stops.

No more eight-figure options packages. No more partying. No more X. Just one strip-mining accident of a hangover and lots of Mercedes payments. The stock falls to around Houston’s sea level. And everybody goes home all sweaty and putrid. And then some go to jail, even sweatier.

Lots of Enron employees held lots of Enron stock in their 401ks. And doing so was actively encouraged by the company. And so lots of good employees got kee-rushed out there, suddenly broke and jobless and – oh, by the way, on the persona non grata list because everyone affiliated with a meltdown like that is Chernobyl-level radioactive.

Sorcerer’s Stoned

But for all its shenanigans, Enron really wasn’t unique in its promotion of company stock to employees. It was pretty run-of-the-mine, doing the same things as lots of public companies to entice employee ownership of stock. And that includes not just companies as of the turn of the millennium. That includes companies today.

Some employees get, say, 15% discounts on company equity purchases made via special programs. Others get their 401k matches only in company stock. And others are awarded fairly large chunks of their compensation in company equity via Employee Stock Ownership Plans (ESOPs).

And all this action encompasses a tremendous number of people.

In fact, ESOPs alone are estimated to apply to around 13.5 million employees. Including other employee ownership plans like those administered through 401ks, the number of affected employees is like 28 million. For a total U.S. labor force of just under 160 million, that’s a big slice of the population pie impacted by these kinds of programs.

So it’s not too surprising that lots of household wealth is found concentrated in employer stock.

What is surprising is that, by various measures and empirical studies, each dollar of household wealth held in employer stock may be worth as little as $0.36.

(A good literature review is found in this research article summarizing some of the various approaches used by economists to arrive at figures like $0.36 or $0.58 on the dollar.)

Although the mathematical particulars and the datasets and the conclusions of these various studies differ a little, there are a few themes that emerge with more or less consensus:

  • Many employees invest in their own employers via equity purchases as part of a special program and in their individual brokerage accounts.
  • Often, employees hold a majority of their total wealth (and an even larger piece of their retirement savings) in company stock.
  • Employees hold this stock for much too long, often never selling it.
  • As a result, employees are insufficiently diversified and thus subject to devastating financial losses separate and apart from the risks due to investing in a company also responsible for paying their wages.

Most studies attempt to quantify this non-diversification risk by identifying the volatility (or other risk measures) of the employer stock and asking: Given this volatility/risk, what level of return would be obtained in a properly diversified portfolio?

The answers generally tell us:

  • Risk-adjusted returns from a diversified portfolio would be much greater.
  • As the concentration of an employee’s holdings in company stock rise, the “losses” increase dramatically.
  • Often, returns from a diversified portfolio held over a multi-year period (3-years or more) would be more than double those actually obtained, given volatility.

The studies also tell us:

  • Employees do a terrible job intuitively understanding these risks and substantially discount the problem.
  • Employees seem to conceptually understand the problem of investing in a company that also pays their wages, but are spectacularly creative at rationalizing why their particular case is different.
  • The employees with the most risk attributable to stock/wage concentration are among those most likely to invest substantial amounts in their employers’ stock.

Fantasia

“Jeez, FL, I get it. Investing in your employer’s stock is like skydiving into a tornado,” you say. “But, uh, I get a sweet discount on my company stock and that’s the only way I get 401k matching and my company’s the best ever. Those guys in the C-suite are geniuses who are revolutionizing the world. And I’ve got an inside track on it all.”

Ok, so yeah. What to do?

We know it’s bad to invest in your own employer’s stock for a variety of diversification reasons. And we know that $1 in employer stock might really be worth only, say, $0.40 in economic value, given the risks entailed.

But real-world issues mean it’s not just as simple as saying no to grass.

So here are some pretty good guidelines distilled from the research in this field. They may not be comprehensive for each unique circumstance, but they’re proffered as general themes that can provide some broad direction in this very complex area.

(Note: If you’re an officer of the company, a major shareholder subject to public reporting disclosure requirements and/or you maintain executive control over the company, your considerations will be different than the employees for whom these guidelines apply. But you knew that already.)

1. Sell Immediately

Many shares of stock obtained via company programs can be sold immediately without penalty. These should be sold at precisely the time they’re granted. Always.

Some shares granted via company programs can be sold immediately but carry a tax penalty if they’re not held for as long as 2 years. In these instances, it’s almost always better to sell immediately and take the tax hit than it is to hold on and wait for the beneficial tax treatment. That’s because the risk-adjusted losses from concentration usually exceed the incremental tax cost. This is pretty much always the case unless you’re in the tippy-top marginal tax bracket. But even then, it’s a close call.

Some grants must vest, or must be held a certain period before sale at market value, or must meet other conditions, etc., etc. before they can be liquidated. Broadly, these grants should be allowed to mature and then be sold immediately. Just be wary of allowing too large a proportion of your wealth to accumulate in vehicles like this.

2. Get Matched (And Then Sell Immediately)

If your 401k matching is only available in company stock, you still want that matching. So take it. And then you should exchange the company stock for another plan option as soon as you can.

You’ll probably have to do this sort of exchange regularly. But it’s 100% worth the effort.

3. Get Informed (And Then Sell Immediately)

If your 401k matching is only available in company stock, you should also inquire with your plan administrator and/or HR whether any alternative matching schemes are available.

If not, you might check into the latest thinking on fiduciary duties in connection with these plans. Some companies are changing policies in light of liability issues, with changes improving 401k flexibility for employees. You could help lead the charge.

4. Just Don’t Do It

Never, ever, ever, ever, never-ever-ever invest in your employer’s stock via your own accounts. If you hold any shares, they should have been discounted or granted somehow, and you should be holding them the minimum amount of time possible before selling.

Don’t believe you know better. Don’t think you’ve got the inside track. Don’t get sucker-punched by “familiarity bias” or whatever you’d like to call it. Don’t think you’re a “bad” employee for not buying in. Be smart and diversify properly – as in, don’t hold any of your salary-payer’s stock.

5. Question Authority

Take a hard look at the advice of any expert who says it’s probably okay to hold up to 10% or 15% of your portfolio in your employer’s stock.

If pressed, that expert is likely to point to Meulbroek, whose investigation implies this 10% to 15% range is where “losses” from non-diversification don’t look so bad. They might also cite a study implying that 8.3% of the portfolio’s ok. But don’t buy it!

Those studies explicitly lay out the basic economic arguments against taking on risk associated with stock/wage concentration. In a sentence: There’s no way to ever be duly compensated (via higher returns) by taking on the added risk of holding employer stock; you can’t diversify that risk away and so you simply shouldn’t do it.

Which means if you’re unlucky enough to work at Enron 2, you could end up out of your job as well as 15% of your wealth, rather than just out of your job. Since there’s no apparent upside to being invested in your own employer’s stock, but there is obvious downside, the optimal allocation into your employer’s stock is 0%.

Magic Hat

Because you Luchadores are a sharp bunch, someone’s thinking: If it’s bad to own my company’s stock, it must be awesome to short the company’s stock. I’d be guaranteed to win!

Sorry, but it doesn’t work that way. I won’t get into the particulars here. But it’s not a good strategy.

One additional risk-mitigation measure that does have some theoretical value is to avoid investing in equities of companies in your employer’s economic sector. Since economic buffeting that affects your employer would be expected to similarly impact these peer companies, this measure would further decouple your portfolio’s performance from your wage performance and thus diminish risk.

All of which means it’s a good idea to keep your investing portfolio and your wage income as far away from one another as possible. Because, no matter how you slice it, when investing in your employer’s stock, 1 almost never equals 1.

Luchadores, are you invested in your employer’s stock? Do you face any challenges diversifying away from those holdings?

14 Comments

Libre Your Mind