Last Updated on December 29, 2021 at 1:01 pm
Do you have stock options from your employer? Then you are likely to be overexposed to individual stocks. That is the bulk of your portfolio could be from just one or two shares. This is a huge concentration risk and must be handled systematically. Since I know many readers suffer from this problem, I requested Sebi registered fee-only investment advisor Vikram Krishnamoorthy to discuss solutions to this problem.
About the author: Vikram is a member of fee-only India (FOI) and part of the freefincal fee-only planner list. He is an MBA in Finance and a Post Graduate in Financial Planning from Canada. He provides fee-only financial planning and investment advisory services for individuals and families from all over India. His website is: insightful.in
Companies often compensate their employees with equity incentives, encouraging employees to become its shareholders too. By doing so, they align the interest of the employee with that of the company and its shareholders. It motivates employees to contribute to the growth of the company and financially benefit from that growth, in a more direct way.
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But as an individual investor, how does this fit into your overall finances and goals? What are the impacts and risks that investors should consider when participating in such equity incentive programs? It is important to look at this benefit as part of your overall plan, asset allocation and risk profile.
Variations in company share incentive programs
There are many variations in these equity incentive offerings. These programs are offered by both private and public limited companies. In India, it is more prevalent in the IT industry and among startups. Below are some of the most common variations offered by companies.
Restricted Stock Units
RSUs or ‘Restricted Stock Units’ are stocks awarded by the company to their employees, free of cost, but have certain restrictions on how the employee can become the ‘owner’ of these stocks. Often, RSUs are awarded when joining the company or on a regular basis as an incentive. But in most cases, the employee cannot ‘own’ the shares immediately when awarded. The ownership of the stocks happens slowly over a period of time, based on the ‘vesting’ schedule. It incentivises the employee to stay longer in the company and profit from the growth of the company.
Employee Stock Options
ESOPs or ‘Employee Stock Options’ are not free stocks like RSUs. The employee is given the ‘option’ or the right to purchase a certain amount of shares at a certain pre-determined price, within a certain period. Just like in RSUs, ESOPs can be granted but may not be exercised immediately. It may have to ‘vest’ over a period of time, after which the employee is allowed to exercise the option of buying it. If the employee does not exercise his option to purchase within the specified time, the option expires. The employee benefits financially by selling the shares for a higher price than the ‘exercise price’ that he paid at the time of purchase.
Employee Share Purchase Plan
EPP or ‘Employee Share Purchase Plan’ allows employees to purchase the company’s share, often at a discounted price from the normal market price. The employee pays for this purchase through deductions in their salary. Since these are mostly publicly listed shares, they are more liquid as the employee can freely sell the shares in the market.
There are many other factors that differentiate the actual benefits that the employee gets, in terms of vesting, voting rights, dividend rights, public vs private shares, taxation etc. These may differ drastically from company to company. Irrespective of which route the company offers their equity incentives, the employee becomes a shareholder of the company and should consider how it impacts his overall finances.
Part of asset allocation and equity exposure
Firstly, such holdings should be considered as part of your overall assets, and not ignored as some future benefit. It is important for investors to evaluate its merits, and include it in their overall portfolio and asset allocation, based on their risk profile. Ideally, this should be considered under the ‘equity’ asset class, although in some cases, it may not behave like a traditional publicly listed stock.
Secondly, within the equity asset class, it has to be treated as any other equity holding. One of the important principals of equity investing is ‘diversification’. When an investor has too much exposure to one company, even though it may be a company he knows a lot about, it breaks this core principle of equity investing.
No matter how big or unique a company is, there are always risks when owning a single company share and not diversifying. A company may be impacted by issues that are outside its own control, like the economy, sector risks, technology changes, etc. There are also unexpected issues that may arise within the company, such as management changes, fraud, etc. If things go bad, the stock may lose its value quickly, impacting the net worth and allocation drastically.
For some investors, such stock holdings form a very high percentage of their overall net worth and can skew their equity exposure drastically. I have worked with some investors where these single stock holdings are about 75% of their net worth. If I tell you to invest 75% of your net worth in a single stock in the market, I am sure you would not do it, no matter how promising the company may look. But when it comes to our own employer’s stock, we make this exception.
So, investors should treat these holdings, firstly as ‘equity’ under their asset allocation, and within that equity exposure, these stocks should be part of a bigger, diversified portfolio of stocks and mutual funds. This should be reviewed every few months and efforts should be made to exit these holdings on a regular basis so that the asset allocation balance is maintained at all times.
Familiarity bias
Our biases have some of the biggest influences in our investment decisions, often leading to irrational and illogical decision making. In my opinion, the biggest problem for an investor is himself. Keeping emotions out of investment decisions is a huge challenge, and in this specific scenario, we are dealing with ‘familiarity bias’.
The common justification for being overexposed to their company’s stocks is, “I know my company well, so….”. There is a feeling of comfort in investing in something we are involved in or have a better knowledge of. Just because you know your company better than others, it does not mean your company is ‘special’ as an investment. It is just another company and is susceptible to the risks that any company faces.
Greed is another emotion that investors need to fight. As mentioned above, investors should try to diversify out of such large equity holdings regularly. However, it is not easy to exit when you see great returns. Many companies are overvalued, especially with the bull run in recent times. Employees may see their stock values rise considerably and may feel like there is no end to the growth potential of their company. But history has always taught us that these runs come to an end, sooner or later. Rather than waiting to sell stocks at its peak, investors should regularly cash out of such large holdings to balance out, irrespective of what they think about the company’s potential.
Don’t be over-invested in your employer
When I say ‘invested’, I do not mean only in terms of financial investments. Remember that your income and career is also dependant on your employer. Tying your income and major investments to the same company is double the risk. If things go bad with the company, your income may be impacted, but also the savings that you may have to fall back on may be impacted as well at the same time.
Employers also use this incentive to entice good employees to stay longer, by not giving ownership of the shares immediately, but gradually over a period of time. Many employees do not take up better opportunities that may come their way, just to stay and get the shares vested. Many investors even plan career changes based on such vesting schedules. It is important to look at the overall career prospects when making such a decision and not just focus on a single company’s stock vesting.
Conclusion
These equity incentive programs are a big financial benefit to employees. In many cases, this benefit turns out to be much bigger than the salary they earn. However, investors should not get carried away by their biases and emotions, and should always remember that they are still invested in a single stock.
To be successful investors, we need to be rational, diligent and keep emotions out of investing. It is important to understand the big picture of our financial goals and investments and use this as a tool to enhance our overall financial life in an efficient and structured manner.
Please join me in thanking Vikram for his insights. If you wish to work with Vikram, you can contact his website: insightful.in
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