Company Stock & Diversification

Posted By: Advisor Analyzer Team

We’ve all heard the story about the Ferrari driving Microsoft janitor from the heyday nineties. You know the one who in lieu of cash, decided to accept Microsoft stock as his annual bonus. Riding the coat tails of the internet bubble, the janitor was handsomely rewarded for his fidelity to the company. While far from shining floors and cleaning windows, most working Americans undoubtedly share similar visions when determining the investment allocation of their 401K or other employer sponsored retirement plan. As the old adage goes, you don’t put all your eggs in one basket. The phrase has been uttered from the mouth of every financial expert and pseudo expert alike. However, taking this one step further, it may be advisable to not only separate your eggs, but to buy them from different stores.

Income and Diversification

Diversification is a strategy for investors to spread their funds across many investments. The obvious objective is that the price decline of one position will be completely offset or at least minimized by another position’s appreciation. Technically speaking, diversification is the reduction of unsystematic or firm specific risk in one’s portfolio. Therefore, a bad quarter from a specific firm will not have a pronounced impact on the overall portfolio value. However, for most employees, future compensation and earnings is highly correlated to employing company’s overall profitability. When profits are high, the employee will reap the benefits via higher bonuses and pay raises. Conversely, when times are bad, the employee may experience stagnant or reduction in pay and in extreme situations, termination. In essence, a firm’s employee is implicitly invested in the firm with which he is employed, since the employee’s future earnings will be directly linked to his employer’s profitability and success.

Employer Stock and Diversification

When employees allocate a portion of their retirement fund to the purchase of company stock, the benefits of diversification are potentially reduced dramatically. When the employer experiences periods of high profitability, not only will overall compensation rise, but the employee may enjoy price appreciation from their retirement portfolio as well. However, when times slow and earnings growth turn negative, both earnings and the retirement portfolio may experience simultaneous reductions. Therefore, the act of investing in company stock amplifies the effects of the employer’s performance.

Unfortunately, purchasing shares of employer stock is an all too common occurrence. Sometimes, the shares are obtained as part of a stock based incentive compensation. Others consciously purchase employer shares from full faith and confidence in their company’s products and services, and a genuine belief in the firm. Still others may feel most comfortable investing in what’s familiar.

 

While the logic and reasoning behind such purchases is arguable, the potential reduction of diversification benefits is an unavoidable consequence. Suppose a firm experiences an extended period of weak earnings and poor stock performance which results in high scale corporate layoffs. A terminated employee with a retirement fund invested in non related companies may have a better performing portfolio than one that invested in their employer’s stock. The retirement portfolio of the employee invested in company stock is unable to provide a hedge at a time the funds are needed most.

 

As a real world example, take the case of Enron. The retirement fund of Former Enron employees were heavily invested in Enron stock. Therefore, both salary and funds set aside for retirement were highly attributable to the success of Enron’s earnings and stock price. Upon its demise, many Enron employees not only faced the difficulties of losing their job, future hardships resulted from losing a substantial portion of their retirement funds as well. Had these employees owned shares of outside companies, the losses may not have been as severe.

Conclusion

Therefore, next time you decide to invest a large portion of your retirement assets behind your employer, make sure to assess the potential consequences of your decision. While there is nothing wrong with believing the company you work for, employees should always be aware of the heavy investment they have already made with their employer when they first decided to take their job. Your future income and retirement portfolio may be too highly correlated to your firm’s overall success.