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Don't Let Stock Options Unbalance Your Portfolio by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research May 25, 2004 When the value of your portfolio rests on a single stock, you risk financial disaster if that stock declines. Thousands of Enron employees found themselves in this position when Enron stock plunged from $90 per share in August 2000 to less than $1 per share in November 2001.* Many investors do what Enron employees did—maintain a high concentration of their employer's stock in their portfolios. Are you one of them? According to work done by the Schwab Center for Investment Research, you should be concerned if a single stock accounts for 10% or more of your total equity exposure. And alarm bells should really start ringing if that number jumps to more than 20%. What percentage of the equity portion of your portfolio is made up of your employer's stock? When calculating the total, consider your 401(k), stock purchase plan investments and any employer stock you may have in a brokerage account—and one other asset many people overlook: your stock options.
The benefits of diversification
Diversification can benefit your portfolio by spreading investment risk and potentially providing steadier returns. A diversified portfolio is typically less volatile—less vulnerable to the ups and down of the market or a particular stock. For more, see The Portfolio Pyramid: How To Diversify Your Investments. Even though you didn't have to put up any cash for your options at the time of grant, they should still be viewed seriously for what they represent: compensation you accepted in lieu of cash for all your hard work. Not accounting for stock options in your diversification strategy can be risky, especially if they represent a large portion of your portfolio, along with company stock. For example, let's say the strike (exercise) price for a grant is $25 and your employer's stock is trading at $45 per share. The spread is $20 per share ($45 - $25). If your employer's stock drops to $35 per share, your spread drops to $10 per share ($35 - $25). Your stock options have lost 50% of their value, which could have a dramatic effect on your overall financial situation. When calculating how much of your employer's stock makes up your portfolio, include the current value of your vested stock options—what they'd be worth if you exercised them today. If your overall position in your employer's stock represents more than 20% of your total equity exposure, you should consider taking action to properly diversify your portfolio. Let's look at how you can do this. Diversify with stock options You might consider reducing your exposure to company stock by developing an accelerated exercise-and-sell strategy for your stock options. This will allow you to invest the money in other assets. However, if you expect the value of your employer's stock to increase, you may want to delay an exercise. Or, you could exercise some options and sell the stock to diversify, and retain some of your options for a later exercise in order to maximize their value. Exercising options carries tax implications you need to consider. For example, incentive stock options qualify for special tax treatment if you meet the holding period requirements. If you sell these shares before meeting the required holding periods, you lose the special tax treatment. Exercising ISOs may also trigger alternative minimum tax. For more, see Stock Options And Taxes: What You Don't Know Can Cost You. An effective exercise-and-sell strategy takes careful planning. Make sure you talk with an investment advisor and/or tax advisor before taking action. A knowledgeable professional should be able to help you establish a multi-year exercise strategy—one that seeks to minimize the tax hit, increase the efficiency of your cash flows, and potentially maximize your option benefit within the context of your overall financial picture and long-term goals. Diversify by changing your 401(k) investment mix If your employer stock represents more than 20% of your stock portfolio, you can also diversify by transferring some or all of your employer stock into other investments offered by your 401(k). Check with your plan administrator or employee benefits department for more information, and don't forget to ask about any restrictions on transfers. They may not be able to give you specific investment advice, but they can explain how your plan works. The bottom line When it comes to employer stock and stock options, you need to consider many factors, including:
*Source: Schwab Center for Investment Research with daily close price data from Datastream. The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, or legal, tax, or investment advice, or a legal opinion. Individuals should contact their own professional tax advisors or other professionals to help answer questions about specific situations or needs prior to taking any action based upon this information. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed. (0504-9623) Return to Top |
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