Categories: Behavioral Finance
      Date: Jan 28, 2011
     Title: Employer Stock – The Double Whammy

Enron is the poster child of the employer stock double whammy--lose your job, lose your life savings. At the end of 2000, Enron employees held on average 62% of their 401K assets in Enron stock. The stock price peaked at $90 per share in August 2000, and employees were feeling smart as they watched their account balances soar. By the end of 2001, Enron had filed for bankruptcy, many employees had lost a significant portion of their retirement savings, and over 95% of them had lost their jobs.

This couldn't happen to you...or, could it?

As it turns out, Enron isn't the only example of a company imploding and giving employees the double whammy--it is just the most memorable. A number of other companies, bankrupt or near bankruptcy, have experienced significant job losses while employee 401K balances tanked due to high allocations in falling employer stock. These include Countrywide Finance, Color Tile, Lucent, and (my favorite) Bear Stearns. You would expect those highly paid financial professionals at Bear Stearns would have been savvy enough to diversify away from their own company stock, but apparently many were not. Of course, if they were such smart money managers, maybe they would have seen what a precarious position their own company was in.

Maybe your situation is different. You feel your job is safe and your company stock has been an excellent investment. What is so wrong with holding a significant portion of your net worth in your employer's stock? Please consider these reasons why it may not be such a great idea.

• First, a concentrated position in any one (not just your employer's) stock results in you taking more risk than you are being compensated for by the expected return on your investment. In finance-speak, you are taking on "unsystematic risk" that can, and should, be diversified away--without lowering your expected return. You are missing out on one of the only free lunches available to the common investor! Although the risk you are taking with a significant allocation to one stock may be difficult to grasp, here are a couple of data points to consider:
  • On average, the price volatility (as measured by standard deviation--the most common metric of stock risk) is at least 2.5 times higher for a single stock than for a highly diversified portfolio of stocks.
  • Although a single stock may significantly out-perform a diversified portfolio, it is much more likely (on average) for a single stock to under-perform the market by a wide margin. For the twenty years from 1984 to 2003, only 6% of the stocks in the S&P 500 significantly out-performed the average by more than 5% per year. On the downside, however, 27% of the stocks underperformed by more than 5% per year. For every big winner, there were more than five big losers.
• Second, even if you decide a concentrated position in a single stock is a still a good idea, why would you choose your employer's stock? Imagine someone is holding a gun to your head and forcing you to choose one single stock to invest over 50% of your life savings in. However, they are very nice about it and let you choose this single stock from the over 5,000 exchange traded stocks in the U.S. They even give you ample time to research and choose the one single stock that gives you the best balance of risk and expected return--after all, this is your retirement nest egg we are talking about. What are the chances that the one stock you choose to gamble your life savings on, out of this cornucopia of choices, just happens to be the company who employs you? Talk about coincidences! Do you really think the stock of the company you work for is the best you can do? (Come on--anyone who is even marginally paying attention at work is pretty aware of how screwed up things are at their own company. There must be times you think you are working at the same company as Dilbert.)
• Finally, your human capital, or earning power, is arguably your biggest asset and currently "invested" with your employer. Do you really want your financial capital and your human capital all invested in the same place? Many people just don't realize the risky position they have put themselves in.
  • Most would agree that losing a job is both emotionally and financially difficult for a person and their family. It is one of those big risks in life that the average person needs to consider and prepare adequately for.
  • Most would also agree that losing a big portion of your investable assets can be terribly upsetting. Not only could it set back your retirement plans by many years, but it could significantly impact your lifestyle today and in the future.
  • Now, for an unsettling vision, imagine these events happening in the same week. Imagine your spouse, who trusted you with the investment decisions, looking at you in shock and dismay as the circumstances unfold. Unfortunately, the risk of you losing your job and the risk of your company stock falling off a cliff are positively correlated--but, you don't have to expose your family to this double risk.

The risk of holding too much company stock has always been obvious to some. And, due to the well publicized events at Enron and elsewhere, many others have taken steps to diversify their portfolios. However, the risk of over concentration in employer stock still exists. We'll look at it further in Part 2.