Equity Award Center

Managing Risk

Try to avoid risks associated with overconcentration. Diversification and hedging are two ways to help reduce concentration risk.

How can I manage my risk?

Rande Spiegelman

When you're thinking about risk, consider all your sources of income and retirement savings. For many people, that will include a salary, a 401(k), bonus compensation, and equity awards. In other words, both your short-term finances (in the form of your paycheck and benefits) as well as your long-term finances (in the form of company stock) may be linked to your employer. That sets you up for exposure to what the financial pros call nonsystematic risk: the risk of investing in a specific company. If your overall wealth is tied up in a single stock, you risk a major financial setback if the stock declines.

According to work done by the Schwab Center for Financial Research, you should be concerned if any one stock (including your employer's) 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%. (This rough rule of thumb assumes the rest of your portfolio is adequately diversified and your overall equity position is a significant part of your portfolio. If stocks only make up, say, 10% of your portfolio, a concentrated equity position may not be as much of a concern relative to your overall wealth.)

How stock options fit in

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. 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.

One way to manage risk associated with stock options is by adopting an accelerated exercise-and-sell strategy, which 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. 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.

Managing risk through diversification and hedging

To mitigate company-specific risk, you can invest in a number of companies across various sectors and industries, with no more than 4% to 5% (preferably 2% to 2.5%) of your total equity exposure represented by any one company's stock. Anything over this amount could expose you to more risk than you're comfortable with—above and beyond a certain level of nondiversifiable systematic risk (market risk) you can't get rid of.

Another way to manage risk is by hedging. A hedge is simply a strategy to help defend against financial loss, particularly if you have an overly concentrated position. Even if you have a diversified portfolio, investment hedges can also be used to offset potential losses when you're temporarily unwilling (or unable) to sell. For instance, if you're worried the bottom may drop out of the market—but you don't want to sell and incur taxes on your gains, or you're several years out from your vesting date on restricted stock—you might enter into a temporary hedge to protect your positions. If you’re seeking to hedge company stock, be sure to check with your employer regarding existing no-hedge rules, if any.

The bottom line

By selling your employer's stock and using the proceeds to buy stocks in other sectors or industries, you're helping to spread your risk around. It sounds obvious enough, but many employees tend to hold onto their company stock in spite of the risks. So when you receive a large grant of company stock, it's worth asking yourself: if you had the equivalent dollar amount, would you put all of it into company stock, or would you buy something else?

Read more:

Hedging Your Investments >
Strategies for Hedging and Diversification >

Rande Spiegelman, CPA, CFP®, is Vice President of Financial Planning at the Schwab Center for Financial Research. Spiegelman specializes in personal financial planning, including income tax, estate tax, retirement, cash flow net worth, compensatory stock options, employee plans, investments and portfolio planning.

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