The Perils of Owning Your Company's Stock
MIAMI (TheStreet) -- We see far too many employees holding their employer's stock in their 401(k) plans. These employees have signed up for a great deal more risk than they need to.
The general rule that diversification is good doesn't stop at the company fence. A diversified portfolio helps protect investors against all the things that will go wrong that we can't even imagine today. Any first-year finance student knows diversification carries no penalty in return reduction and is as close to a free lunch as investors can hope for. Likewise, concentration of investments is bad, leading to higher risk without any higher expected return.
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| Microsoft employees have reasons to feel otherwise, but the general rule is that stock diversification doesn't stop at the company fence. |
But, the problem of employer stock is particularly acute. Economists make a distinction between investment capital and "human capital." Human capital is the value the individual brings to society, and may be (very roughly) measured in lifetime wages. Human capital is a "wasting" asset. It's also a risky asset. Once it's gone, it's gone. The flying fickle finger of fate can intervene at any time. So at least some of it must be converted to investment capital over time. That's why we set up retirement plans, buy life and disability insurance and save.
Another problem with human capital is that it is difficult to diversify. Few of us can manage more than one career at a time, so it makes sense to diversify away from the employer risk in our investment capital. After all, if your company does poorly, some employees (or all of them) may find themselves out of a job at the same time their stock is in the tank.
It's easy for employees to deny the problems of the employer, or think they have "insider" knowledge of the company's position. Many employees have bought company stock right up to the hour the doors close -- in fact, employees are often kept carefully in the dark to keep up morale or ensure an orderly liquidation. Employee briefings are not held to the same standards that analyst briefings are.
But even high-growth healthy companies can experience dramatic swings in stock prices, subjecting employees' finances to gut-wrenching rollercoaster swings.
Companies often make stock available to their employees at a discount. This discount can take the form of incentive stock options and discount stock purchase plans. It's easy to see the advantages for the employer: increased loyalty and identification with corporate goals by the recipients, reduced payroll costs and even a reduced cost of capital. Start-up companies often finance their operations with "funny money" stock options.
But it's a mixed bag for the employees. On one hand there may be something to be said for turning employees into rugged capitalists. On the other hand it defies the logic of diversification and compounds the problem of lumping the human capital of your job into your investment capital. These employees are supposedly making informed, free-market choices, and of course we have all heard about all the millionaire employees at Microsoft(MSFT) , where early employees essentially won the lottery. But for every one of them there are hundreds of employees laboring away with company stock going nowhere. Investing is not about winning the lottery; it's about building security and reducing risk.
It's shocking that Congress allows corporations to fund their retirement plans with company stock. Tax-qualified retirement plans are supposed to be for the exclusive benefit of the beneficiaries, and fiduciary standards should apply. Employees trapped in pension plans requiring funding with company stock should complain to management and write their elected representatives.
How much of your employer's stock should you own? Maybe zero. Employees that hold more than a token amount of their employer's stock do so at their peril.
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